Chapter 7 - Insourcing / Outsourcing


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Chapter 7 - Insourcing / Outsourcing

  1. 1. Bozarth and Handfield, Chapter 7 (3/3/03) Chapter 7 Outline: Purchasing Introduction Dell Computer Corporation Cisco Systems Why Purchasing is Critical The Changing Global Competitive Landscape Financial Impact Performance Impact The Sourcing Decision Advantages and Disadvantages of Insourcing and Outsourcing Total cost analysis Boxed Example 7.1: Total cost analysis at ABC Company Sourcing Strategies Honda of America The Purchasing Process Needs Identification Description Supplier Identification and Evaluation Supplier Selection Purchase Order Preparation Follow-Up and Expediting Receipt and Inspection Invoice Clearance and Payment Records Maintenance 1
  2. 2. Bozarth and Handfield, Chapter 7 (3/3/03) Supplier Evaluation Systems Boxed Example 7.2: Supplier Evaluation at Electra Company Trends In Purchasing Management Long-term Contracts and Consolidation Supply Base Reduction Global Purchasing Supplier Performance Measurement Supplier Technology Information Technology Professionalism in Purchasing Chapter Summary Discussion Questions Exercises 2
  3. 3. Bozarth and Handfield, Chapter 7 (3/3/03) Chapter 7: Purchasing Introduction One of the most important decisions facing any business is the question of whether to produce some product or service internally or to purchase it from an outside supply chain partner. In this chapter, we will discuss some of the important considerations surrounding sourcing decisions, and how firms should go about managing the purchasing process. But to start, let’s consider the very different experiences of Dell Computers and CISCO Systems. Dell Computer Corporation1 At first glance, Dell Computer would seem to be in a tenuous position. “Dell Computer has no proprietary technology,” writes Charles Fine. “In fact, the company's position in the supply chain has it squeezed between Intel and Microsoft upstream, two of the computer industry's most powerful players, and a downstream market populated by millions of well-informed consumers who can choose from dozens of computer companies that assemble almost indistinguishable personal computers." Yet Dell Computer has not only survived, but thrived. As of May 2000 Dell had a market capitalization of nearly $130 Billion and a gross profit margin of over 20%. Dell accomplished this feat primarily through superior supply chain management, including 1 From: Book Excerpt: The Primacy of Chains, Charles Fine, Supply Chain Management Review, Spring, 1999. Pp. 79-91) 3
  4. 4. Bozarth and Handfield, Chapter 7 (3/3/03) effective purchasing of products and services. Dell buys state-of-the-art technologies and logistics services, but internally handles its purchasing, order management, and assembly activities. The company’s strategic reliance on superior supply chain partners, coupled with its own core competencies, has made Dell a leader in a highly competitive industry. Cisco Systems2 Perhaps no company underscored the unlimited potential of the New Economy more than Cisco Systems, Inc. Cisco was poised to become the world’s first trillion-dollar enterprise, wielding a market cap greater than that of General Electric in pursuit of annual revenue growth projected at 30 to 40 percent. Two of the things that gave Cisco its glow were its development of a virtual supply chain with limitless capacity and its ability to provide extraordinarily high reliability to its customers. Another apparent strength was its approach to manufacturing: It didn’t build most of what it sold. John Chambers, president and CEO, once explained, “Our approach is something we call ‘global virtual manufacturing.’ First, we’ve established manufacturing plants all over the world. We’ve also developed close arrangements with CEMs [contract equipment manufacturers]. So when we work together with our CEMs – and if we do job right – the customers can’t tell the difference between my own plants and my CEM’s in Taiwan and elsewhere.” But in early 2000, shortages of memory and optical components began paralyzing one path of production. For the first time, Cisco’s supply chain began to experience the kind of growing pains that affected its earnings. When the 2 This section is on Cisco is quoted nearly verbatim from “Why Cisco fell: Outsourcing and its perils”, Lakeman, Boy, and Frev. http:/ 4
  5. 5. Bozarth and Handfield, Chapter 7 (3/3/03) telecommunications infrastructure experienced a severe downturn, customer orders began to dry up … and Cisco neglected to turn off its supply chain. Orders went out, parts began to pile up. Its raw-parts inventory ballooned more than 300 percent from the third quarter to the fourth quarter of 2000. Cisco’s problems culminated in a $2.25 billion write-down. In short, Cisco simply wasn’t able to use outsourcing to scale up or down as quickly as it thought it could. This chapter is divided into two distinct, yet related, parts. In the first half of this chapter, we will discuss the various issues surrounding sourcing decisions, including the insourcing versus outsourcing debate, and various sourcing strategies. We will examine how total cost analysis can be used to augment the strategic analysis of sourcing opportunities. The second half is devoted to the purchasing process itself. Purchasing includes all those activities associated with identifying needs, locating and selecting suppliers, negotiating terms, and following up to ensure supplier performance. Purchasing links a company with its upstream supply chain partners. We take a look at the various activities that make up the purchasing process, including product description, supplier evaluation and selection activities. Finally, we discuss major trends that will affect purchasing management in the years to come.3 3 Adapted from Monczka, R., Trent, R., and Handfield, R., Purchasing and Supply Chain Management, Southwestern College Publishing, Cincinnati, OH: 1997. 5
  6. 6. Bozarth and Handfield, Chapter 7 (3/3/03) Why Purchasing is Critical Purchasing has always been an important, if under-appreciated, function in many businesses. As the cases of Dell and Cisco illustrate, however, several trends have worked together to push purchasing into the limelight. These include the changing global competitive landscape, the financial impact of purchasing, and purchasing’s impact on such performance dimensions as quality, delivery, and technology utilization. The Changing Global Competitive Landscape Firms do not just compete against global competitors, but against their competitors' supply chains. Companies that were content to purchase services and goods from local suppliers are now seeking to build relationships with world-class suppliers, regardless of their location. Managers have come to realize that “to compete globally, you need to purchase globally.” To keep up with global competition and tap into the abilities of world-class suppliers, many companies are putting in place global purchasing systems. GM is a case in point. Harold Kutner is GM's vice president and group executive in charge of world-wide purchasing. Every Friday morning at 6:30 am (Detroit time), Kutner "presides over a global video conference in which dozens of purchasing executives share information and coordinate strategy."4 In addition, a few years back a GM purchasing team completed a 12-day mission to Thailand, Taiwan, South Korea and Japan. The 4 "General Motors Drives Some Hard Bargains with Asian Suppliers", WSJ, 4/2/99. 6
  7. 7. Bozarth and Handfield, Chapter 7 (3/3/03) purpose of the trip was to evaluate 12 tool makers as potential sources of stamping dies, but GM also developed valuable contacts at the same time. Advances in information systems have served as a catalyst for global purchasing efforts. Electronic "blueprints" can now be shared instantaneously with engineers and suppliers around the world. Purchasing requirements for dozens of sites can be consolidated into one large order, giving the organization maximum buyer power. Companies can share anticipated requirements with key suppliers around the clock, allowing suppliers to plan their activities accordingly. Financial Impact If you were to look at the financial statements of an average organization, how much would you guess the company spends on purchased goods and services? In manufacturing, the figure is astonishingly high: the average manufacturer spends approximately 56 cents out of every dollar of revenues on goods and services (see Table 7.1). For some services, such as retailing or wholesaling, the figure can be even higher. Table 7.1: Materials to sales ratios for different industries Industry Materials to sales ratio Food 65.4 Textiles 60.5 Furniture and fixtures 47.2 Chemicals 51.5 Rubber & plastics 50.1 7
  8. 8. Bozarth and Handfield, Chapter 7 (3/3/03) Stone/clay/glass 47.5 Primary metals 64.0 Fabricated metal 50.5 Machinery 47.8 Electrical equipment 43.1 Transportation equipment 60.0 Annual Survey of Manufacturers: 1985, U.S. Bureau of the Census, Government Printing Office, Washington, D.C., 1987, p. 1-8. When much of the firm’s revenue is spent on materials and services, purchasing represents a major opportunity to increase profitability. Consider the following financial information for Lowe's, a service firm in the home improvements retailing sector. Table 7.2 shows earnings for the company for the quarter ending January, 1999, as well as key balance statement figures. 8
  9. 9. Bozarth and Handfield, Chapter 7 (3/3/03) Table 7.2: Selected financial data for Lowe's Company (all figures in $000s) Earnings & Expenses (Quarter ending January, 1999) Sales $2,915,664 Merchandise costs $2,096,331 Pre-tax earning $168,253 Selected balance sheet items Merchandise Inventory $2,104,845 Total assets $6,344,651 From the figures, we can see that the pre-tax profit margin for Lowe's is ($168,253/ $2,915,664) = 5.8%. This means that every dollar of sales generates a little less than 6 cents in pre-tax profit. Furthermore, the quarterly return on assets (ROA) is ($168,253/ $6,344,651) = 2.7%. What can Lowe's do to improve these figures? Note that every dollar saved in purchasing at Lowe's increases pre-tax profit by a dollar. According to the above figures, Lowe's would have to generate about $17 in sales to make the same improvement to the bottom line that saving one dollar in purchasing costs would have. This profit leverage effect is particularly important for low margin businesses, such as retailing. Also note that if Lowe's was able to cut its merchandise costs, this would not only affect profits, but would also reduce the amount of money tied up in inventory. The impact would be a higher ROA figure. To illustrate these points, let's see what would happen if Lowe's was able to cut merchandise costs by just 3%: 9
  10. 10. Bozarth and Handfield, Chapter 7 (3/3/03) Earnings & Expenses (Quarterly) Sales $2,915,664 Merchandise costs $2,096,331 minus 3% savings: - $62,890 $2,033,441 Pre-tax earnings $168,253 plus 3% savings: + $62,890 $231,143 Selected balance sheet items Merchandise Inventory $2,104,845 minus 3% savings: - $62,890 $2,041,955 Total assets $6,344,651 minus 3% savings: - $62,890 $6,281,761 Pre-tax profits would increase 37%, and the new pre-tax profit margin for Lowe's would be ($231,143 / $2,915,664) = 7.9%. Lowe's would have to increase sales by 10
  11. 11. Bozarth and Handfield, Chapter 7 (3/3/03) ($62,890 / 5.8%) = $1.1 billion to have the same impact. In addition, the new quarterly ROA is ($231,143 / $6,281,761) = 3.7%. Performance Impact Purchasing also has a major effect on performance in such diverse areas as quality, delivery and the ability of companies to exploit new technologies. Suppose, for example, that Springfield Hospital has two dialysis machines, each with a special valve that must be replaced every week. As a result, Springfield uses about 50 valves per year. The hospital has two alternative sources for the valves. The cost, quality and delivery lead times for these two suppliers are shown below: Supplier A Supplier B Cost per valve $10 $2 % Good 99.8% 95% Delivery lead time Overnight delivery 1 day to 3 weeks Defective valves cannot be identified until they are installed. Failures cause an interruption in the treatment of patients, which lead to rescheduling nightmares, a reduction in the effective capacity of the dialysis machines and may even result in a medical emergency. The quality of the medical service will clearly fall if Springfield goes with Supplier B. Suppose now that Springfield management has estimated that the cost of a failed valve is about $1000 per incident. Furthermore, if Springfield goes with Supplier A, then 11
  12. 12. Bozarth and Handfield, Chapter 7 (3/3/03) they will be able to get by with one valve as a "back up", since overnight delivery is guaranteed. But if Springfield uses Supplier B, they will need three "back up" valves (about three weeks worth) to protect themselves against Supplier B's unreliable delivery patterns. Even before we calculate all of the costs associated with each supplier, we can see that sourcing valves through Supplier B has the potential to seriously disrupt Springfield's operations. These concerns are reflected in the following cost estimates: Yearly Costs Supplier A Supplier B Valve costs 50 * $10 = $500 50 * $2 = $100 Failure costs 0.2% of all valves fail: 5% of all valves fail: 0.2% * 50 valves *$1000 5% * 50 valves * $1000 = $100 = $2500 Back-up Inventory 1 valve * $10 = $10 3 valves * $2 = $6 Total Cost: $610 $1,106 Purchasing can also help an organization incorporate state-of-the-art technologies into its products and services. When Chrysler introduced the Neon automobile, they realized that suppliers would furnish 70% of the value of the car. In order to bring the car out on schedule, the team invited 25 makers of key parts such as seats, tires, and 12
  13. 13. Bozarth and Handfield, Chapter 7 (3/3/03) suspension components to send engineers to Chrysler’s engineering facility.5 What was the result of this effort? The car cost less to produce and included all of the proposed design features. The Sourcing Decision Before we get into a detailed discussion of the purchasing process, it makes sense to first talk about the sourcing decision. At its most basic level, sourcing decisions address which products and services will be provided in-house (known as insourcing) and which will be provided by a firm’s supply chain partners (outsourcing). The sourcing decision is also known as the make-or-buy decision. Quite simply, sourcing decisions are critical to operations and supply chain managers (including those in purchasing) because it tells them what they will and will not be responsible for. Suppose, for example, that a company decides to insource a product or service. In this case, operations and supply chain managers must determine the capacity and resources they need, the most appropriate manufacturing or service processes to use, and the information systems they need to coordinate operations. But if the company decides to outsource the product or service, the emphasis shifts to the purchasing activities associated with identifying the most qualified suppliers and managing the buyer-supplier relationship. Advantages and Disadvantages of Insourcing and Outsourcing 5 Woodruff, David, “Chrysler’s Neon: Is this the Small Car Detroit Couldn’t Build?”, Business Week, May 3, 1993, pp. 116-126. 13
  14. 14. Bozarth and Handfield, Chapter 7 (3/3/03) Table 7.3 summarizes the advantages and disadvantages of insourcing and outsourcing. Insourcing gives a company a high degree of control over its operations, which is particularly desirable if the company owns proprietary designs or processes. Insourcing can also lower manufacturing costs, but only if a company enjoys the business volume necessary to achieve economies of scale. Unlike many smaller pharmaceutical firms, for instance, Merck is large enough to afford a sales force dedicated exclusively to selling only Merck products. Finally, insourcing encourages the development of core competencies. As we saw in Chapter 2, a major part of any business strategy development effort is identifying and building core competencies—organizational strengths or abilities, developed over a long period, that customers find valuable and competitors find difficult or even impossible to copy. Products or processes that could evolve into core competencies are prime candidates for insourcing. On the downside, insourcing can be risky because it decreases a firm's strategic flexibility. The semiconductor industry is a good example of the risks of insourcing. In 1995, at least a dozen new semiconductor plants were under construction in the United States, including three for Intel and two for Motorola. At the time the average cost of a chip fabrication plant was about $1.5 billion, and was expected to rise to $3 billion by 1999. To make matters worse, some of the associated manufacturing technologies had life cycles as short as six months, after which they were expected to be superseded by newer technologies. As a result, semiconductor manufacturers faced the very real risk of investing in old process technologies just as newer ones emerged. To justify plant 14
  15. 15. Bozarth and Handfield, Chapter 7 (3/3/03) expansions under these conditions, managers had to show that investing in new capacity would bring a quick payback6. Finally, if suppliers can provide a product or service more effectively than the company itself, managers must decide whether to commit scarce resources to upgrading their processes or to outsource the product or service. Attempting to catch up to suppliers technologically can be an expensive proposition, which could restrict a firm’s ability to invest in other projects, or even threaten its financial viability. Outsourcing typically increases a firm's flexibility and access to state-of-the-art products and processes. As markets or technologies change, many firms find changing supply chain partners easier than changing internal processes. In addition to increasing a firm's strategic flexibility and access to new technologies, outsourcing improves its cash flow. With outsourcing, less investment is required up front in the resources needed to provide a product or service. The benefits can be significant. By using contract manufacturers, Dell Computer supported $3 billion in annual revenues with only $60 million of fixed assets7. Of course, outsourcing has its risks. Suppliers may misstate their capabilities: their process technology may be obsolete, or their performance may not meet the buyer’s expectations. Consider the experience of Apple Computer. When demand for a new line of Macintosh computers increased dramatically during the 1990s, Apple accumulated an order backlog of more than $1 billion. The company could not obtain timely delivery of critical parts, including modems and custom chips, because many of them had been custom-designed and outsourced from a single supplier. Apple’s inability to deliver the 6 Source: Adapted from Erin Anderson and Barton J. Weitz, "Make-or-Buy Decisions: Vertical Integration and Marketing Productivity," Sloan Management Review, Spring, 1986, pp. 14-15. 7 Shawn Tully, “You’ll Never Guess Who Really Makes...,” Fortune, 3 October 1994, 124. 15
  16. 16. Bozarth and Handfield, Chapter 7 (3/3/03) highly valued product alienated many customers, who were not willing to wait for the new computers8. Control is also an issue in outsourcing. Buying firms may need to create costly safeguards to regulate the quality, availability, confidentiality, or performance of outsourced goods or services. At the extreme, they may lose key skills and technologies that are part of their core competencies. To counteract such threats, many companies oversee key design, operations, and supply chain activities and keep current on what customers want and how their products or services meet those demands9. Table 7.3 summarizes the advantages and disadvantages of insourcing and outsourcing. Table 7.3: Advantages and disadvantages of Insourcing and Outsourcing INSOURCING Advantages Disadvantages • High degree of control. • Reduces strategic flexibility. • Ability to oversee the entire process. • Requires high investment. • Economies of scale and/or scope. • Potential suppliers may offer superior products and services. OUTSOURCING Advantages Disadvantages • High strategic flexibility. • Possibility of choosing a bad supplier • Low investment risk. • Loss of control over the process 8 “Is Spindler a Survivor?,” Business Week, 2 October 1995, 62. 9 “The Internet Age”, Business Week, October 4, 1999, pp. 103-104. 16
  17. 17. Bozarth and Handfield, Chapter 7 (3/3/03) • Improved cash flow. • & core technologies • Access to state-of-the-art • "Hollowing out" of the corporation products and services. Table 74 looks at the debate from another angle: What factors will influence the decision to insource or outsource? As the table suggests, insourcing will generally be more favorable in situations where environmental uncertainty is low (thereby reducing the risk of investing in capacity), supplier markets are not well developed, and the product or service being considered is not directly related the buying firm’s core competencies. In contrast, outsourcing becomes more attractive as competition in supplier markets increases, the product or service is not seen as strategically critical, and environmental uncertainty makes internal investment a risky prospect. Given this, it makes sense that a lot of high tech companies, facing short product life cycles and uncertain market conditions, outsource more often than firms in more stable industries. Table 7.4: Factors That Affect the Decision to Insource or Outsource Factor Favors Favors Insourcing Outsourcing Environmental uncertainty High Low Competition in the supplier market Low High Ability to monitor supplier’s performance High Low Relationship of product / service to buying firm’s core High Low competencies. 17
  18. 18. Bozarth and Handfield, Chapter 7 (3/3/03) Total Cost Analysis Ultimately, managers must understand the cost issues associated with insourcing versus outsourcing. Determining the actual cost of a product or service is a complicated task requiring both good judgment and the application of sound quantitative techniques. In this section we will first examine the direct and indirect costs managers must consider in making such decisions. Then we will run through a simple cost analysis. Table 7.5: Insourcing and outsourcing costs Insourcing Outsourcing Direct Costs Direct material Price (from invoice) Direct labor Freight costs Freight costs Variable overhead Indirect Costs Supervision Purchasing Administative support Receiving Supplies Quality Control Maintenance costs Equipment depreciation Utilities Building lease Fixed overhead Table 7.5 identifies the major cost categories associated with insourcing and outsourcing decisions. As the table shows, these costs are typically divided into direct 18
  19. 19. Bozarth and Handfield, Chapter 7 (3/3/03) and indirect costs. Direct costs are those costs that are tied directly to the production of a good or service, such as materials costs, labor costs, and variable overhead. If, for example, a product requires 1.3 square feet of sheet metal, and the cost of sheet metal is $0.90 per square foot, the direct cost of the sheet metal is: $0.90 * (1.3 feet) = $1.17 Indirect costs, as the name implies, are not tied directly to production levels. Building lease payments, depreciation of equipment, and staff salaries are classic examples of indirect costs, which in essence represent the price of doing business. To understand the true total cost of insourcing or outsourcing, managers must assign, or allocate, indirect costs to individual units of production. That task is not as easy as it may sound, however. Suppose managers are trying to decide whether to make a product in house or outsource it. They estimate they will need to spend $600,000 just to design the new product. If they plan to produce 200,000 units, they might assign the design cost as follows: $600,000 / 200,000 units = $3.00 per unit. But what if the results of the design effort could be applied to future products? Should part of the design cost be assigned to those future products, and if so, how? For this reason, outsourcing costs are usually easier to determine than insourcing costs. With outsourcing, the indirect costs are included in the direct purchase price shown on the 19
  20. 20. Bozarth and Handfield, Chapter 7 (3/3/03) supplier’s invoice. Generally, the only additional costs that need to be considered in the outsourcing decision are inbound freight (a direct cost) and administrative costs associated with managing the buyer-supplier relationship (such as purchasing and quality control). In contrast, the bulk of insourcing costs may fall into the indirect category, making the task of to estimating the true total cost more difficult. In determining total costs, managers must consider the time frame of the sourcing decision. If an insourcing arrangement is expected to be of relatively short duration, as it might be for a product with a limited life cycle, then perhaps only direct costs and some portion of the indirect costs should be applied. In the short run, firms are better off recovering their direct costs and some portion of their indirect costs than risking a significant decline in their business. However, if managers expect an insourcing arrangement to become part of ongoing operations, they should consider all relevant costs that might reasonably be incurred over the long term, including all indirect costs. In the long run, a firm must recover all its costs or go out of business. ************************************************************ Boxed Example 7.1: Total cost analysis at the ABC Company With this background, let's walk through a cost analysis of a simple sourcing decision at the ABC company. One of ABC's Taiwanese suppliers has bid on a new line of molded plastic parts that are currently being assembled at ABC’s facility. The supplier has bid $0.10 per part, given a forecasted demand of 200,000 parts in year 1, 300,000 in year 2, and 500,000 in year 3. Shipping and handling of parts from the supplier’s facility is estimated at $0.01 per unit. Additional inventory handling charges should amount to 20
  21. 21. Bozarth and Handfield, Chapter 7 (3/3/03) $0.005 per unit. Finally, purchasing costs are estimated at $20 per monthly purchase order. Although ABC’s facility is capable of producing the part, it is currently running at 95% capacity. Investing in another machine will cost $10,000, depreciated over the life of the product. Direct materials can be purchased for $.05 per unit. Direct labor is estimated at $.03 per unit plus a 50% surcharge for fringe benefits; indirect labor is estimated at $.011 per unit plus 50% for benefits. Up-front engineering and design costs will amount to $30,000. In addition, the comptroller has insisted that overhead (an indirect cost) be allocated to the parts at a rate of 100% of direct labor cost. Table 7.6: Total Cost Analysis for the Sourcing Decision at ABC INSOURCING Operating Expenses: Direct labor $0.0300 Fringe (50%) $0.0150 Direct materials $0.0500 Indirect labor $0.0110 Fringe (50%) $0.0055 Equipment depreciation $0.0100 ($10,000 depreciated over 1 mill. units) Fixed overhead $0.0300 Engineering / design $0.0300 ($30,000 over 1 million units) TOTAL INSOURCING $0.1815 (1) COSTS OUTSOURCING Purchase price $0.1000 Shipping and handling $0.0100 Inventories $0.0050 Administrative costs $0.0072 ($20 X 12 X 3 / 1,000,000) TOTAL OUTSOURCING $0.1222 (2) COSTS SAVINGS ((1) - (2)) X 1,000,000 $59,300 21
  22. 22. Bozarth and Handfield, Chapter 7 (3/3/03) Table 7.6 shows one possible analysis of the costs of insourcing versus outsourcing this part; different managers might come up with a slightly different analysis. For example, ABC’s managers might want to experiment with different allocation rates for overhead and depreciation expense, to see how a change in the rate might affect the decision. They might also want to consider the effect of exchange rates on the supplier’s costs. Suppose, for example, that the outsourcing costs are based on an exchange rate of 30 Taiwanese dollars to one U.S. dollar. If the exchange rate were to fall to 25 to 1, ABC’s outsourcing costs could rise by 20%. The point is that even a relatively simple cost analysis requires managerial judgment and interpretation. Cost analyses are most useful when they are considered jointly with strategic factors. ****************************************************************** Sourcing Strategies Once the decision has been made to outsource a product or service, firms still face some choices. In single sourcing, the buying firm depends on a single company for all or nearly all of a particular item or service. In multiple sourcing, the buying firm shares its business across multiple suppliers. The advantages and disadvantages of each are shown in Table 7.7. In the past, very few North American organizations would have considered voluntarily using a single supplier due to the inherent risks. This perception has changed somewhat because of the example set by Japanese firms who have used single sourcing to 22
  23. 23. Bozarth and Handfield, Chapter 7 (3/3/03) achieve continuous price, quality and delivery improvements. Today, companies must consider both multiple sourcing and single sourcing, and the advantages and disadvantages of each approach. 23
  24. 24. Bozarth and Handfield, Chapter 7 (3/3/03) Table 7.7: Advantages and disadvantages of multiple / single sourcing Multiple Sourcing Single Sourcing Advantages Disadvantages Advantages Disadvantages Create Reduces supplier Volume leveraging Knowing they have competition loyalty – suppliers – as volumes go up, the business, may not be willing cost per unit suppliers can actually to “go the extra decreases as increase prices in the mile” for the supplier spreads short term purchaser fixed costs over larger volume. Spread risk (in event Can increase risk in Transportation Increased supply risk of a fire, strike, etc. the event of a economics – fewer – if a disaster occurs, at one supplier) shortage – supplier shipments and lower the buyer can be left may only supply per unit without a source of preferred customers transportation costs supply Required if the May result in Reduce quality Buyer can become purchased volume is different product variability, and have “captive” to a too great for one attributes with a standardized supplier’s technology supplier varying quality product – while other suppliers are surging ahead with newer technology that has better performance Desired if firm Can actually result in Build stronger Do not know if you wishes to meet increased prices over relationship with have the “best” obligations to time, as suppliers are supplier, and gain supplier available support minority reluctant to provide access to design and suppliers cost savings ideas engineering capabilities Can ensure that Suppliers can let Required when Dangerous strategy suppliers do not performance slide if supplier has a if the supplier has become volume is not high proprietary product limited capacity – “complacent” enough to merit their may “shut down” attention the buyer if takes on too much business Required when volume is too small to split between two suppliers One way that companies can overcome the dilemma of the single sourcing / multiple sourcing decision is through a compromise known as cross sourcing. In this 24
  25. 25. Bozarth and Handfield, Chapter 7 (3/3/03) strategy, the company uses a single supplier for a certain part or service in one part of the business, and another supplier with the same capabilities for a similar part in another area of the business. Each supplier is then awarded new business based on their performance, creating an incentive for them to improve. This also provides for a backup supplier in case the primary supplier cannot provide the required volume. At Honda of America, cross-sourcing is extensively used as part of their purchasing strategy (see boxed insert at end of chapter). A similar purchasing strategy is dual sourcing. This strategy is exactly what it sounds like – two suppliers are used for the same purchased product or service. Typically, the split of the business is 70% to Supplier A, and 30% to Supplier B. In this manner, Supplier A is “looking over his shoulder”, knowing that if performance suffers it will lose the business to Supplier B. Dual sourcing in some ways combines the best of both worlds. To cap off our discussion of the sourcing decision and sourcing strategies, consider the purchasing efforts of Honda of America, described below. Honda has integrated single and dual sourcing, as well as supplier development and integration, into its sourcing efforts. Also notice how Honda has "gone global" by expanding the number of North American suppliers. 25
  26. 26. Bozarth and Handfield, Chapter 7 (3/3/03) Honda of America Honda manufactures almost everywhere in the world, including Japan, the U.S., Germany, Mexico, the United Kingdom, and Brazil. When Honda first started building cars in Ohio in 1982, the company would import car kits from Japan, and assemble them. In the late 1980’s, Honda changed this philosophy to “We will build where we sell, and buy where we build.” Suppliers are evaluated according to the QCCD-M approach: Quality, Cost, Delivery, (Product) Development, and Management. The last element refers to the supplier's management attitude. Honda emphasizes that this is the most important part of the equation: if a supplier has quality, cost, delivery, or development problems, they can be improved through joint effort. However, if management’s attitude is not positive and they are not willing to work in a cooperative manner with Honda, they can never become a Honda supplier. To provide feedback to suppliers on a regular basis, suppliers receive a “report card” that provides a “grade” on each of the areas of QCCD- M. This helps suppliers to analyze, control, and improve their performance. When a problem occurs with a supplier, Honda follows the “Three A” rule: That is, go to the “Actual Place”, touch the “Actual Part, and view the “Actual Situation.” Honda will even send in teams of experts to help the supplier improve their operations. In addition, Honda also holds an annual supplier conference to inform, inspire, challenge, and reward suppliers. Nevertheless, competition in the supply base is very important. Honda believes in using a single source for the majority of their parts purchased, yet they will dual source by platform. An example of this strategy is as follows: Supplier A sources 26
  27. 27. Bozarth and Handfield, Chapter 7 (3/3/03) steering wheels for Civics, and Supplier B sources steering wheels for the Accord. Either supplier can make either part, but each is a single source by platform. When a new model is introduced, both suppliers may bid on the extra volume, with the best price and best performing supplier likely to get the business. The Purchasing Process Now that we have described the issues surrounding sourcing decisions, let’s examine in detail the purchasing process, which includes all the steps that must be completed when someone within the organization requires some product, material or service. Some people also refer to this as the purchasing cycle to emphasize the iterative nature of these activities. These activities, or steps, are highlighted in Figure 7.1. There are two things to keep in mind as we describe the purchasing process. First, how much effort a company spends on these activities will differ greatly from one situation to the next. The purchasing process leading to a $3 Billlion contract for 100 jets is much different than that for a routine purchase of office supplies! Second, as you look at Figure 7.1, recognize that companies can often gain a competitive advantage by performing these activities better than their competitors. Many organizations, for example, use information systems to automate routine purchase order preparation, while others use sourcing management teams to improve the outcome of supplier evaluation and selection efforts. Needs Identification 27
  28. 28. Bozarth and Handfield, Chapter 7 (3/3/03) The purchasing cycle begins with the identification of a need (i.e. a requirement). In some cases, this need may take the form of a component, raw material, sub-assembly, or even a completely finished item. In other cases, the need may be a service, such as consulting or building maintenance. Because purchasing is responsible for acquiring products and services for the entire organization, the information flows between purchasing and other areas of the organization can be extensive. Figure 7.1: The purchasing process Needs Identification Description No Is there a preferred supplier? Source Identification Yes & Evaluation Supplier Selection Purchase Order Preparation Follow-up & Expediting Receipt & Inspection Order Cycle Invoice Clearance & Payment Records Maintenance 28
  29. 29. Bozarth and Handfield, Chapter 7 (3/3/03) Internal users communicate their needs to purchasing in a variety of ways. For routine items and services, users often use purchase requisitions or reorder point systems to communicate their needs to purchasing. A purchase requisition is an internal document completed by a user that informs purchasing of a specific need. Although a variety of formats exist, at a minimum a purchase requisition should include a detailed description of the material or service, the quantity and date required, estimated cost, and authorization. A reorder point system is another method to “kick-off” the purchase of routine items. Each item in a typical reorder point system has a predetermined order point and order quantity. When inventory is depleted to a given level, the system signals the material control department (or the buyer in some organizations) to issue a request to the supplier. While requisition forms and reorder point systems have traditionally been paper-based, this is changing quickly as more firms switch to computer-based processing for routine items and services. Description Whatever the good or service, purchasing must ensure that the user's needs get communicated to potential suppliers in the most efficient and accurate way possible. How purchasing accomplishes this will differ dramatically from one situation to the next. A variety of methods exist for communicating the user's requirements10. Description by market grade or industry standard might be the best choice for standard items, where 10 For more information on the purchasing process, see Monczka et. al., 1997. 29
  30. 30. Bozarth and Handfield, Chapter 7 (3/3/03) the requirements are well understood and there is common agreement between supply chain partners about what certain terms mean. Description by brand is used when a product or service is proprietary, or when there is a perceived advantage to using a particular supplier's products or services. A builder of residential communities, for example, might tell his purchasing staff to purchase R21 insulation for walls and finish- grade lumber for the trim and fireplace mantles. In addition, he might also specify Georgia-Pacific's Catawba® hardboard siding, Kohler® faucets, and TruGreen- Chemlawn® lawn treatment for all the homes. As you can see, the use of brand names, market grades, or industry standards provides purchasing with an effective and accurate "shortcut" for relaying user's needs to potential suppliers. More detailed and expensive methods of description will be needed when the items or services to be purchased are more complex, when "standards" do not exist, or when the user's needs are harder to communicate. Three common methods include description by specification, performance characteristics, and prototypes or samples. In some cases, an organization may need to provide very detailed descriptions of the physical characteristics of an item. We refer to such efforts as description by specification. Specifications can cover such characteristics as the materials used, the manufacturing process required, and physical dimensions of the product. Consider one extreme example: the special heat shield tiles used on NASA’s space shuttles. Each tile has a unique shape and location on the space shuttle. Furthermore, each shield must be able to protect the space shuttle from heat generated by reentry into the Earth's atmosphere. In providing a description of these tiles, NASA will almost certainly include specifications regarding the exact dimensions of the tiles and the composite materials to 30
  31. 31. Bozarth and Handfield, Chapter 7 (3/3/03) be used in making them. Such information might be relayed in the form of detailed blueprints and supporting documentation. Furthermore, NASA will likely specify the precise manufacturing steps and quality checks to be performed during the manufacture of the tiles In contrast, description by performance characteristics focuses attention on the outcomes the customer wants, not on the precise configuration of the product or service. The assumption is that the supplier will know the best way to meet the customer's needs. A company purchasing hundreds of PCs from Dell Computer might demand 1) 24-hour support available by computer or phone, and 2) 48-hour turn-around time on defective units. How Dell chooses to meet these performance characteristics is their choice. Firms often develop prototypes or samples to share with their suppliers. Prototypes can provide critical information on the look or feel of a product or service. Such information is often difficult to convey in drawings or written descriptions. Note that prototypes or samples are not limited to physical products. An excellent example is a prototype information system that a company might share with potential software vendors. The prototype may include sample output screens and reports. Through the prototype, the company can give its software vendors a clearer idea of how the company expects its users to interact with the system. Supplier Identification and Evaluation Once a decision is reached to outsource a product or service, the firm must identify and often evaluate external sources. The purpose of this section is to describe major areas of 31
  32. 32. Bozarth and Handfield, Chapter 7 (3/3/03) supplier evaluation. You should recognize, however, that the amount of effort will increase as: • The complexity of the product or service increases • The amount of money that is committed increases • The length of the proposed buyer-supplier relationship increases. A full-blown evaluation process begins with the development of a list of potential suppliers. This list may be generated from a variety of sources, including market representatives, information databases, and trade journals. Some of the different criteria that a company may use to assess potential suppliers include, but are not limited to, the supplier’s: • Process and design capabilities • Management capability • Financial condition and cost structure • Planning and control systems • Environmental regulation compliance • Longer-term relationship potential These criteria are worth talking about in more detail.11 Although it may not be possible to obtain all the relevant information, data that can be obtained will help the buying firm assess the potential for a successful match. 11 Adapted from Monczka, R., Trent, R., and Handfield, R., Purchasing and Supply Chain Management, Southwestern Publishing, 1997. 32
  33. 33. Bozarth and Handfield, Chapter 7 (3/3/03) Process and Design Capabilities. As we discussed earlier in the book, processes consist of the technology, equipment, people and information systems used to manufacture a product or deliver a service. Since different process types have various strengths and weaknesses, the buying firm must be aware of these characteristics up front. When the buying firm expects suppliers to perform component design and production, it should also assess the supplier’s design capability. One way to reduce the time required to develop new products is to use qualified suppliers who are able to perform product design activities. Management capability. Assessing a potential supplier’s management capability is a complicated, but important, step. Different aspects of management capability include management's commitment to continuous process and quality improvement, overall professional ability and experience, ability to maintain positive relationships with its workforce, and management’s willingness to develop a closer working relationship with the buyer. Some questions that might be asked include: • What is the professional managerial experience? • Is there a high degree of turnover among managers? • Has management committed itself to total quality management and continuous improvement? 33
  34. 34. Bozarth and Handfield, Chapter 7 (3/3/03) • Has management prepared the company to withstand the competitive challenges of the next two decades? Financial Condition and Cost Structure. An assessment of a potential partner’s financial condition almost always occurs during the evaluation process. Selecting a supplier who is in poor financial condition presents a number of risks. First, there is the risk that the organization will go out of business, disrupting the flow of goods and information in a supply chain. Second, suppliers who are in poor financial condition may not have the resources to invest in required personnel, equipment or improvement efforts. In cases when the supplier is a publicly traded company, specific financial information can be obtained from sources such as 10-K reports, Moody's Industrials, and Dunn and Bradstreet. Many key financial ratios can also be calculated using income statements and balance sheets. In technology-intensive industries, the buying firm might also look at the company's research and development (R&D) expenditures as a percent of sales. Moreover, the firm should track such ratios for possible "red flags" that may signify a potential financial difficulty. Understanding the supplier’s cost structure also helps determine the effectiveness and efficiency of the potential partner’s operations. The cost structure includes labor costs, material costs, manufacturing or process operating costs, and overhead costs. Collecting this information can be a challenge during the initial evaluation process. A potential supplier may not have a detailed understanding of its costs at the level of detail required. Furthermore, many companies consider cost data to be 34
  35. 35. Bozarth and Handfield, Chapter 7 (3/3/03) proprietary. Even when little or no data is available, some understanding of a potential partner’s cost structure is a critical part of the evaluation process. Planning and Control Systems. Planning and control systems includes those systems that release, schedule, and control the flow of work in an organization. As we shall see in later chapters, the sophistication of such systems can have a major impact on supply chain performance. Among the questions the buying firm should ask: • Does the supplier have computerized systems for planning material, personnel and capacity needs? If not, why not? If so, does the supplier use these systems? • Does the supplier track key performance measures, such as throughput time, quality levels, and costs? Are these measures compared to performance objectives or standards? • How easy is it for customers to interact with the supplier’s planning and control systems? This last point is particularly important to organizations interested in effective supply chain management. When interaction is high, information about the customer’s needs flow easily to the supplier, and the customer can, in turn, retrieve important information from the supplier. Consider the relationship between Wal-Mart and Proctor and Gamble (P&G). When a Wal-Mart store sells a particular P&G item, the information 35
  36. 36. Bozarth and Handfield, Chapter 7 (3/3/03) flows directly to P&G’s planning and control systems. P&G can then plan production and schedule shipments accordingly. Furthermore, Wal-Mart can easily find out when a P&G shipment will arrive at one of its distribution warehouses, thereby allowing Wal- Mart to consolidate this shipment with others on the way to individual stores. Environmental Regulation Compliance. The 1990s brought about a renewed awareness of the impact that industry has on the environment. The Clean Air Act of 1990 imposes large fines on producers of ozone-depleting substances and foul-smelling gases, and governments have introduced laws regarding recycling content in industrial materials. As a result, a supplier's ability to comply with environmental regulations is becoming an important criterion for supply chain alliances. This includes, but is not limited to, the proper disposal of hazardous waste. Longer-Term Relationship Potential. In some cases, a firm may be looking to develop a long-term relationship with a potential supplier. Perhaps the supplier has a proprietary technology or foreign market presence that the sourcing firm wants to tap into. Regardless of the reason, a firm that wants to establish a longer-term relationship with a supplier must go beyond evaluating the areas just discussed. The firm will need to ask some additional questions12: 12 Spekman, Robert E. "Strategic Supplier Selection: Understanding Long-Term Buyer Relationships,"Business Horizons, July-August, 1988., pp. 80-81. 36
  37. 37. Bozarth and Handfield, Chapter 7 (3/3/03) • Has the supplier signaled a willingness or commitment to a partnership-type arrangement? • Will the organization immediately revert to a negotiated stance if a problem arises? • Does the supplier have a genuine interest in joint problem solving and a win-win agreement? • Will there be free and open exchange of needed information across the organizations? • How much future planning is the organization willing to share with us? • Is the need for confidential treatment of information taken seriously? This is not a complete list of questions that can be asked when evaluating the possibility of a closer longer-term relationship. This list does provide, however, a framework concerning the types of issues that are important in this area. Supplier Selection Final supplier selection begins once the firm completes the activities required of the supplier evaluation process. For some items, firms may maintain a list of preferred suppliers who receive the first opportunity for new business. A preferred supplier has demonstrated its performance capabilities through previous purchase contracts. By maintaining a preferred supplier list, purchasing personnel can quickly identify suppliers with proven performance capabilities. Competitive bidding and negotiation are two methods commonly used for final supplier selection when there is not a preferred supplier. 37
  38. 38. Bozarth and Handfield, Chapter 7 (3/3/03) Competitive Bidding. Competitive bidding in private industry entails a request for bids from suppliers with whom the buyer is willing to do business. This process is typically initiated when the purchasing manager sends a request for quotation (RFQ) form to qualified suppliers. Purchasers often evaluate the resulting bids based on price. If the lowest bidder does not receive the purchase contract, the buyer has an obligation to inform that supplier why it did not receive the contract. Competitive bidding is most effective when13: • The buying firm can provide qualified suppliers with clear descriptions of the items or services to be purchased. • Volume is high enough to justify the cost and effort. • The firm does not have a preferred supplier. Buying firms use competitive bidding when price is a dominant criterion and the required items or services have straightforward specifications. In addition, government agencies often require competitive bidding. If major non-price variables exist, then the buyer and seller usually enter into direct negotiation. Competitive bidding can also be used to identify a short list of suppliers with whom the firm will begin detailed purchase contract negotiation. Negotiation. Negotiation is a more costly, interactive approach to final supplier selection. Face-to-face negotiation is best when: 13 Dobler, Lee, and Burt, Purchasing and Materials Management, 1990, Irwin:Homewood, Illinois, p. 204. 38
  39. 39. Bozarth and Handfield, Chapter 7 (3/3/03) • The item may be a new and/or technically complex item with only vague specifications. • The purchase requires agreement about a wide range of performance factors. • The buyer requires the supplier to participate in the development effort. • The supplier cannot determine risks and costs without additional input from the buyer. One thing is certain--the process that firms use to select suppliers can vary widely depending on the required item and the relationship that a firm has with its suppliers. For some items, a buyer may know which supplier to use before the development of final specifications even occurs. For standard items, the competitive bid process will remain an efficient method to purchase relatively straightforward requirements. The bid process can also reduce the list of potential suppliers before a buyer begins time-consuming and costly negotiation. Purchase Order Preparation Once performance of the contract begins, the buyer must periodically signal to the supplier that delivery of the product or service is required. The most common way of doing this by releasing Purchase Orders (P.O.s) More and more, POs are released through electronic data interchange (EDI), the instantaneous electronic transfer of purchase documents between the buyer and seller. By eliminating the time associated with the flow of physical documents between supply chain partners, EDI can reduce the time it takes suppliers to respond to customers needs. 39
  40. 40. Bozarth and Handfield, Chapter 7 (3/3/03) This, in turn, leads to shorter order lead times, lower inventory, and better coordination between the supply chain partners. Not surprisingly, as Table 7.8 shows, the use of EDI has increased significantly over the last several years. 14 Table 7.8: Transmitting material requests to suppliers through EDI • 74 percent of firms currently have EDI capability with some part of their supply base. • In 1997, firms using EDI had electronic linkage with 60 percent of their total supply base (versus 18 percent in 1993). This 60 percent of the total supply base will represent 70 percent of total purchase dollars. • Almost 65 percent of total purchasing transactions (purchase orders, amendments, shipping notices or schedules) are linked directly with suppliers through EDI in 1997 Source: 1998 Executive Purchasing and Materials Management Seminar, Michigan State University, East Lansing, Michigan Follow-up and Expediting 14MSU Purchasing and Materials Management Executive Seminar, Michigan State University, 1996. This study used data collected by researchers at The Eli Broad Graduate School of Management at Michigan State University and Lehigh University from the MSU Executive Purchasing and Materials Management Seminar. Data were collected by having seminar participants complete a questionnaire prior to attending the seminar. The respondents were primarily from large manufacturing firms. 40
  41. 41. Bozarth and Handfield, Chapter 7 (3/3/03) Someone (typically Purchasing) must monitor the status of open purchase orders. There may be times when a purchaser has to expedite an order or work with a supplier to avoid a delay in a shipment. A company can minimize order follow-up by selecting only the best suppliers and developing internally stable forecasting and ordering systems. In proactive follow-up, managers track orders and stay in touch with suppliers, to ensure that they are making good progress on the open purchase order. This can help prevent problems before they occur. On the other hand, reactive follow-up occurs when an order doesn’t show up, and the buyer must discover what happened, if the shipment left the supplier’s plant, and why it hasn’t arrived. This type of follow-up typically results in expediting the shipment, usually at substantial additional costs. Receipt and Inspection When the order for a physical good arrives at the buyer’s location, it is received and inspected to ensure that the right quantity was shipped, and that it was not damaged in- transit. Assuming that the delivery occurred on-time, it will be entered into the company’s inventory database, and become part of the company’s working inventory. In cases when the supplier is performing a service, the buying company must ensure that the service is being delivered according to the Statement of Work issued in the Purchase Order. That may mean checking with the actual users within the organization who requested the service in the first place, and ensuring that all is going as planned. Deviations from the Statement of Work must be noted and passed on to the supplying organization. 41
  42. 42. Bozarth and Handfield, Chapter 7 (3/3/03) Invoice Clearance and Payment Once the item or service is delivered, the buying firm will issue an authorization for payment to the supplier. Payment is then made through the organizations’ “Accounts Payable” department. This is increasingly being accomplished through electronic means. Suppliers are more often being paid through electronic funds transfer (EFT), which automatically sends a payment from the buying organizations’ bank account to the suppliers’ bank account. More and more organizations are moving to integrated systems where all purchase orders, receipts, and payments are made electronically. This form of business is generally referred to as electronic commerce. Records Maintenance After the product or service has been delivered and the supplier paid, a record of critical events associated with the purchase is entered into a supplier performance database. The supplier performance database accumulates critical performance data over an extended period of time, helping purchasing identify trends or patterns in supplier performance. These data are often used in future negotiations and dealings with the supplier in question. In the next section, we discuss how such performance evaluation systems function. 42
  43. 43. Bozarth and Handfield, Chapter 7 (3/3/03) Supplier Evaluation Systems The purchasing process does not end with the receipt of an ordered item or the selection of a supplier. Buyers need some way to identify areas requiring attention and to track supplier performance improvement over time. A supplier evaluation system supports the continuous management and improvement of suppliers. Monitoring supplier progress is especially critical if the supplier is developing a new product or process technology. The buyer must be sure that a supplier can meet timing targets throughout each phase of the development process. Without a measurement system, a buyer has little insight into supplier performance over time, and would lack the quantitative data necessary to support future purchase decisions. A major issue when evaluating supplier performance is the frequency of evaluation and feedback. For example, should a buyer receive a daily, weekly, monthly, or quarterly supplier quality performance report? While most firms recognize the need to notify suppliers immediately when a problem exists, there is little consensus about the frequency for conducting routine or scheduled supplier evaluation. For many firms, this overall evaluation may occur only 1-2 times a year. In some cases, companies use supplier evaluation systems to develop an overall summary score of a given supplier’s performance. Scoring systems can provide the buyer with quick, summary information on suppliers. The buyer (and sometimes the supplier) can quickly see how the supplier stacks up against other suppliers. Such scores can serve as input into future negotiations and purchasing decisions. The following example provides an illustration of how the supplier evaluation process takes place, using a weighted-point evaluation system. 43
  44. 44. Bozarth and Handfield, Chapter 7 (3/3/03) *********************************************************************** Boxed Example 7.2: Supplier Evaluation at Electra Company The Electra Company has decided to re-evaluate the performance of three of its suppliers of integrated circuit boards (ICBs). In the past, the company has shared all business equally with the suppliers, and has amassed a significant amount of information on their performance history. It must now award a large contract for 500,000 ICBs to be delivered over the next year for a new product they are building. Table 7.9 summarizes the performance of its three major suppliers with regard to price, quality, and delivery. Table 7.9: Summary data for three possible suppliers Criteria Aardvark Conan the Electronics Beverly Hills Inc. Electrician Price $4 / unit $5 / unit $2 / unit Quality 5% defects 1% defects 10% defects Delivery 95% on-time 80% on-time 60% on-time The process begins by developing a weight for each of the criteria used. The sum of the weights must equal 1. In this case, the sourcing team assigned to evaluating suppliers for the new contract has decided that Quality is the most important criteria, followed closely followed by Delivery and Price. Thus, the team assigns the following set of performance weights, based on a consensus among the group (note that the exact criteria and weights may vary, depending on the product or service being purchased). Price = 0.3 Quality = 0.4 44
  45. 45. Bozarth and Handfield, Chapter 7 (3/3/03) Delivery = 0.3 Total = 1.0 Next, the sourcing team evaluates each supplier’s performance on each of the criteria, using the following scale: 5 = Excellent. Performance greatly exceeds our expectations. 4 = Good. Performance clearly meets our expectations. 3 = Average. Performance barely satisfies our expectations. 2 = Fair. Performance falls just below our expectations. 1 = Poor. Performance falls well below our expectations. Based on the product design team's specifications, the Electra sourcing team has determined that the minimum allowable performance for ICBs is $4.80 per unit, 4% defects, and 90% on-time delivery. Thus, they proceed to assign performance scores for each criterion, as shown in Table 7.10. Finally, they calculate a weighted performance score for price, quality, and delivery, by multiplying the weight for each criteria weight by each supplier's respective performance score (e.g. the weighted price performance score for Aardvark is (.3 X 4 = 1.2). Finally, the total score for each supplier is calculated by adding up the price, delivery, and quality scores (e.g. Total Score for Beverly Hills = 0.9 + 2.0 + 0.6 = 3.5). Table 7.10: Weighted performance for three possible suppliers Criteria (Weight) Aardvark Conan the 45
  46. 46. Bozarth and Handfield, Chapter 7 (3/3/03) Electronics Beverly Hills Inc. Electrician Price (.3) $4 / unit $5 / unit $2 / unit (4) (3) (5) Price Score = 1.2 Price Score = 0.9 Price Score = 1.5 Quality (.4) 4% defects 1% defects 10% defects (3) (5) (1) Quality Score = 1.2 Quality Score = 2.0 Quality Score = 0.4 Delivery (.3) 95% ontime 80% ontime 60% ontime (4) (2) (1) Delivery Score = Delivery Score = Delivery Score = 1.2 0.6 0.3 Total Score Total = 3.6 Total = 3.5 Total = 2.2 Based on the results in Table 7.10, the Electra team must now decide on which source to use. Conan the Electrician is clearly out of the running. While this supplier has the lowest price by far, their delivery and quality record is abysmal. This leaves Aardvark and Beverly Hills. Aardvark has a lower price, but needs to improve its quality. Beverly Hills has excellent quality, but they have a problem delivering on-time, and must also find a way to reduce their prices. Because the final scores for the two suppliers are so close, the result of this decision might be one of the following outcomes: • Award the contract to Aardvark, after a detailed negotiation in which they are asked to provide details on how they will improve their quality. • Award the contract to Beverly Hills after a detailed negotiation in which they are asked to reduce their price and explain how they will improve delivery performance. 46
  47. 47. Bozarth and Handfield, Chapter 7 (3/3/03) • Award a dual source contract, in which 50% of the business goes to each of the two suppliers. The contract might state that future volumes will be assigned according to which supplier improves their performance most quickly. *********************************************************************** Clearly, supplier evaluation requires a significant amount of judgment in awarding points and assigning weights. However, the process of identifying key criteria and assigning numerical scores to performance allows purchasers to be more objective and comprehensive in their decision-making. Furthermore, conscientious purchasers will make every effort to back up their ratings with hard data. Trends in Purchasing Management Our chapter would not be complete without a look ahead to the trends affecting purchasing management. The trends and changes we describe here are based on survey data collected annually at Michigan State University from firms worldwide. As the findings suggest, the changes occurring within purchasing are as dramatic as those in any business area. 47
  48. 48. Bozarth and Handfield, Chapter 7 (3/3/03) Long term Contracts and Consolidation A steady increase in the use of longer-term contracts (2 or more years) has occurred since 1990. The percentage of longer-term contracts to total contracts has increased from approximately 24 percent in 1990 to 40 percent of total contracts currently. Additionally, the dollar value of purchases represented by longer-term contracts has increased from 34 percent to 45 percent of total purchase dollars. Within the next several years, at least half of all contracts should be longer-term, representing two-thirds of the total value of all purchases. The pressure to reduce costs has had a major influence on the growth of longer- term agreements. The use of longer-term agreements can reduce dramatically the costs associated with maintaining a relationship between a buyer and supplier. Supplier reduction efforts often precede the development of longer-term purchase agreements with the remaining suppliers. This way, firms can establish long-term relationships with a few, high performing suppliers. Also, longer-term purchase agreements are often a prerequisite to activities requiring closer interaction and cooperation between a buyer and supplier. As purchasers pursue activities that require closer relationships, such as early supplier involvement and EDI, expect the use of longer-term agreements to increase. The use of longer-term contracts is paralleled by an increase in the number of purchase consolidation efforts. Purchase consolidation is the pooling of purchasing requirements by multiple areas in a company, or even across companies. By consolidating their needs, businesses can achieve higher overall purchasing volumes and leverage their purchasing efforts. Consolidation provided tremendous cost savings 48
  49. 49. Bozarth and Handfield, Chapter 7 (3/3/03) opportunities throughout the 1990s and beyond. In fact, most firms have achieved only a moderate level of consolidation, even when opportunities for consolidation exist. Supply Base Reduction In 1990, the average buyer in an organization was responsible for 126 suppliers. By the late 1990s, buyers regularly did business with about 46 suppliers, representing a decline of 63 percent from 1990 levels. Note that a reduction in the number of suppliers a firm maintains is often just a reduction in the total number of first tier suppliers (see Chapter 1). A trend within the automotive industry, for example, has been to rely on larger suppliers to design and build entire subsystems, such as the automobile’s electrical system. Instead of dozens of smaller suppliers providing components for the subsystem, the purchaser uses one major supplier, who then uses dozens of suppliers to help build the system. Global Purchasing In the US, purchases from foreign sources increased from 9 percent in 1990 to 14 percent of total purchases in the late 1990s. Cost reduction pressures along with a need to gain worldwide access to process and product technologies continue to push this trend. These factors will help ensure that a gradual increase in total purchases from international sources will continue. 49
  50. 50. Bozarth and Handfield, Chapter 7 (3/3/03) Supplier Performance Measurement By the late 1990s, more than one half of all firms surveyed had defined minimum levels of acceptable supplier performance, up from one-third of firms in 1990. These levels, often established as part of the performance benchmarking process, are meant to reflect best-in-class or world-class performance standards. The growth in acceptable supplier performance levels is consistent with the growing number of firms maintaining formal supplier performance measurement systems. The number of firms using formalized systems to measure supplier performance has increased dramatically, from 47 percent in 1990 to more than 80 percent in the late 1990s. As we have discussed, without these systems it becomes difficult to make supplier selection decisions, determine where to commit supplier development resources, and track supplier improvement efforts. Supplier Technology Firms forecast a 20-30 percent average increase in their reliance on product and process technology bought from suppliers. There are four major reasons behind this trend. First, more firms are focusing on their core competencies, thereby leading them to off-load non-critical activities to suppliers. Second, there is growing worldwide competition with accompanying cost and quality pressures. Tapping into the best suppliers helps firms meet these cost and quality requirements. Third, nearly every organization is feeling pressure to innovate rapidly and continuously upgrade their performance in critical areas. Suppliers' design and technical expertise can help meet these needs. A fourth reason is that many companies now view time-related capabilities as critical to their success. For instance, in some industries the ability to take new products 50
  51. 51. Bozarth and Handfield, Chapter 7 (3/3/03) from concept to customer in the shortest possible time will rival the highest perceived product quality and the lowest product price in importance. Firms responding to a recent Michigan State survey expected to reduce development times by 40 to 45 percent over the next several years. To achieve this, purchasing must pursue activities that support development time reduction, such as early supplier involvement with computer design interfaces. Information Technology Within the next several years, firms expect to establish electronic linkages with more than 60 percent of their supply base, compared with 20-25 percent today. Furthermore, 65 percent of total purchase transactions (purchase orders, amendments, shipping notices or schedules) should link directly with suppliers through EDI. Perhaps a more important trend is the emergence of Internet-based business-to- business exchanges (B2Bs). B2Bs are on-line trading communities that put hundreds or even thousands of potential buyers and suppliers in touch with one another, and automate the flow of information between the trading parties. A major advantage of B2Bs over EDI is that B2Bs take advantage of standardized Internet protocals to make data interchange much simpler than ever before. This allows even small companies to participate. Public B2Bs are open to any company that meets certain criteria and is willing to pay the fees necessary to join and/or transact with other parties. An excellent example of a public B2B is Ariba ( Private B2Bs, in contrast, limit the trading partners to only a selected group. 51
  52. 52. Bozarth and Handfield, Chapter 7 (3/3/03) Professionalism in Purchasing In the future, purchasing professionals will perform fewer day-to-day buying activities, and spend more time on strategic activities such as supplier evaluation and selection, new product development, and insourcing / outsourcing decisions. To illustrate, many organizations now issue credit cards to selected users. These cards allow the user purchase what they require directly from approved sources. The credit card company issues reports, performs billing, and assumes many responsibilities performed previously by purchasing. Information technology will further reduce the clerical burden placed on purchasing professionals. By relying on information systems, users can order directly what they require through their computer terminal. Also, production planning and control systems will generate orders automatically, based on production requirements. These systems will use EDI to forward component requirements immediately to suppliers, reducing the need for managerial oversight. Another development that will reduce the clerical work assumed by purchasing is the use of suppliers to manage inventory at the customer's site. This is a classic example of an out-sourced activity that was previously performed by purchasing or materials management professionals. These changes concern some purchasing professionals. If, for many years, an individual’s primary responsibility has been to place purchase orders routinely, what happens when job requirements shift or even disappear? The purchasing group at a large Midwest chemical company is currently in transition from “order placing” responsibilities to more strategic activities. 52
  53. 53. Bozarth and Handfield, Chapter 7 (3/3/03) Table 7.11 summarizes the major changes that are occurring in the area of purchasing management. Table 7.11: Trends in purchasing management Area of Purchasing Traditionally. . . … In the Future 1. Contract length Competitive bidding, Long-term contracts (more renewed annually or semi- than 2 years) with annually. performance improvement clauses. 2. Purchase consolidation Products and services Purchases consolidated purchased by individual across business units to business units. leverage volumes and purchasing efforts. 3. Number of suppliers Suppliers switched often, Firms more likely to single- many suppliers used for source or dual-source each purchased product or products or services, to service. improve performance and reduce costs. 4. Location of suppliers Primarily domestic, or even Global sourcing by the best local. suppliers in the world 5. Top management's Purchasing seen as a Purchasing seen as a way to perception of purchasing “nuisance” or non-value- harness suppliers' added activity. capabilities, especially in new product development. 6. Importance of time Long cycle times tolerated; Cycle time a critical order- little involvement of winner; suppliers cooperate suppliers in new product in new product development development process. to reduce product development time. 7. Improving supplier’s Suppliers expected to Buying organizations capabilities improve … or else! improving supplier performance through supplier development programs 8. Supplier performance Random or nonexistent Detailed, formal measurement monitoring of supplier’s performance measurement quality, delivery, and price systems to track price, over time delivery, quality, and other measures. 9. Supplier performance Low standards if any Increasing levels of standards. performance expected. 53
  54. 54. Bozarth and Handfield, Chapter 7 (3/3/03) 10. Reliance on supplier Little to none. Suppliers Suppliers active in new product and process expected to deliver exactly product/process technology. what was asked and no development. more. 11. Electronic information Little or none. Increasing use of EDI, systems linking buyers and B2Bs, CAD/CAM, and web suppliers. to link supply chain partners. 12. Purchasing Primarily clerical – Increased use of technology responsibilities processing purchase orders. for routine activities; more time spent on managing relationships with key suppliers. Chapter Summary Purchasing can contribute significantly to profitability, quality performance, speed of product development, and technological innovation within a firm. Furthermore, executives have come to recognize the important role purchasing plays in importing value in the form of supplier’s capabilities into the organization. However, satisfying internal organizational needs is only part of the buyer's task. There is an external dimension which makes the task even more complex. The size of the supply base, as well as the availability of local suppliers, can limit the number of options available to a buyer. Contemporary supply chain responsibilities require that the purchasing professional act as an initiator and facilitator of strategic supply chain relationships. The increasingly critical task domain of the purchasing field has finally led to management recognition and appreciation of the field’s potential for contributing to long term competitive advantage. 54
  55. 55. Bozarth and Handfield, Chapter 7 (3/3/03) Discussion Questions 1. What are some of the pros and cons of outsourcing? Why do you think many firms are experiencing an increase in their levels of outsourcing? 2. Describe the problems associated with the allocation of indirect costs to a product or service. How does this complicate total cost analyses of sourcing decisions? 3. Someone says to you, “All purchasing does is place orders for goods. What’s the big deal?” Is this true? What is the big deal? 4. What is a preferred supplier? What are the advantages and disadvantages of using preferred suppliers? 5. Under what conditions might a company prefer to negotiate rather than use competitive bidding to select a supplier? 6. In the chapter, we suggested that advanced information systems will automate some of the more routine purchasing activities. What are the implications for purchasing professionals? Is this a good time to join the purchasing profession? Explain. 55
  56. 56. Bozarth and Handfield, Chapter 7 (3/3/03) Exercises Dulaney’s Department Stores has posted the following yearly earnings and expenses: Earnings & Expenses (Year ending January, 2004) Sales $50,000,000 Merchandise costs $30,000,000 Pre-tax earning 5,000,000 Selected balance sheet items Merchandise Inventory $2,500,000 Total assets $8,000,000 1. What is Dulaney’s current profit margin? Its current yearly ROA? 2. How much would Dulaney’s pre-tax earnings increase if merchandise costs were cut by 10%? What would the impact be on the yearly ROA? 3. How much sales would Dulaney have to generate in order to have the same effect on pre-tax earnings as a 10% decrease in merchandise costs? 4. What would the yearly ROA be after a 10% cut in merchandise costs? 5. Looking back at Boxed Example 7.2, suppose Conan the Electrician has implemented a Total Quality Management (TQM) program, and as a result has brought defect levels down to just 1%, the same as Beverly Hills Inc. Recalculate the weighted performance score for Conan the Electrician using the weights provided in the boxed example. Should Electra change their preferred supplier, based on these results? 56
  57. 57. Bozarth and Handfield, Chapter 7 (3/3/03) Flynn Industries has outsourced the delivery of its products, and now wants to develop a tool to help it evaluate its transportation carriers. The first table shows the rating values associated with different levels of price, quality, and delivery performance, as well as criteria weights that reflect the relative importance of these dimensions. To illustrate how the ratings work, suppose a carrier has a damage level of 0.82%. This would fall between 0.75% and 1.0%, thereby garnering a rating of 2. The second table shows actual average performance levels for three carriers. 6. Calculate the weighted average performance for each carrier. Who is “best”? 7. How would the results change if the weights for price, quality, and delivery shifted to 0.6, 0.2 and 0.2 respectively? 8. Based on the results in Problem 1, should Flynn Industries single source or not? What might stop them from single sourcing? Rating Values: Suppliers are rated on a scale of 1-5, depending on their specific performance levels Criterion (weight) 1 2 3 4 5 Price 0.20) > $2.50/lb $2.01-$2.50/lb $1.51-$2.00/lb $1.00-$1.50/lb < $1.00/lb Quality Damage > Damage Damage Damage Damage < (0.20) 1% 0.75-1.0% 0.5-0.74% 0.25-0.49% 0.25% Delivery < 82% on- (0.60) time 82-84% on-time 85-90% on-time 91-95% on-time > 95% on-time Carrier A Carrier B Carrier C Price $1.98/lb Price $2.02/lb $98.00/100lbs Quality 0.35% damaged Quality 0.26% damaged 0.86% damaged Delivery 93% on-time Delivery 98% on-time 83% on-time 57