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Strategic sourcing and partnerships in supply chains –

  1. 1. Strategic sourcing and partnerships in supply chains – the case of the foundry industry Chetan Anil Soman, Narayan Rangaraj, B.Ravi Indian Institute of Technology, Bombay - 400 076 Tel: (+91) 22-576-7882 Fax: (+91) 22-578-3480 Chetan Anil Soman is currently a research associate in Industrial Engineering and Operations Research at the Indian Institute of Technology, Bombay, India. He works in the areas of automotive supply chains and I.T. in manufacturing. Dr. Narayan Rangaraj is an Associate Professor in Industrial Engineering and Operations Research at the Indian Institute of Technology, Bombay, India. His research and teaching interests are in the area of logistics, supply chain management and transport operations. [] Dr. B.Ravi is an Assistant Professor in Mechanical Engineering at the Indian Institute of Technology, Bombay, India. He conducts research and teaches in the areas of concurrent engineering, design for manufacture, process simulation and expert systems for metal casting. [] 1
  2. 2. Abstract Firms have discovered that close partnerships with important suppliers can produce managerial, technological, and financial benefits for the entire supply chain. This increased interest in various types of alliances and partnerships has grown because of competition from foreign producers, technological innovations, and shortened product life cycles. This article presents a strategic sourcing methodology for firms interested in developing supplier partnerships. We discuss various factors leading to partnerships, methods of evaluating a potential partner (customer as well as supplier) and different ways of nurturing the relationship. This methodology is developed on the basis of findings of the authors while conducting case studies of electrical machinery and automobile industries and their suppliers involved in successful partnerships. The foundry industry as a key initial supply chain player is the focus of most of the examples and discussion. The article concludes by discussing the implications of this methodology at operational levels. 2
  3. 3. Keywords: Strategic Sourcing, Supply Chains, Supplier relationships, Castings INTRODUCTION Sourcing and supplier relationships have a strategic significance. This is illustrated by the terminology used in business to describe these activities. One analogy which is commonly used is the one of partners in a common cause, but a stronger image to describe the relationship with key suppliers is that of marriage, which is certainly a more strategic activity than most. In this paper, without carrying the marriage analogy too far, we attempt to show how certain perspectives on sourcing arise very naturally in the strategic framework of supply chain management. The sourcing activity is discussed from various angles: (a) from the determinants of the activity (the good old make or buy decision, but in a new bottle), in next two sections, followed by (b) their implications on supply chain competitiveness, and finally, (c) the evolution of relationships and their stability. The observations are partly motivated by recent studies which involved the foundry industry in India and two of the physical product supply chains that the industry is a part of: the electrical machinery industry and the automobile industry. 3
  4. 4. Many industries today claim to have a supplier strategy and indeed a strategy to the whole sourcing activity. Two extreme options followed in this regard are to integrate suppliers with the assembler into a single, large bureaucracy or to have marketplace relationships with completely independent suppliers. For example, Kathuria (Kathuria, 1996) contrasts the strategies of the two major players in the heavy commercial vehicle sector in India as being representative of these two extreme strategies. TELCO is highly vertically integrated whereas Ashok Leyland has a much larger share of outsourcing [1]. An intermediate option to the above two extreme strategies is that of strategic sourcing. Typical strategic sourcing activity would encompass outsourcing norms (what to make and what to buy), vendor selection, strategic targets for technology and cost performance of vendors and their monitoring, joint investments and so on. These were always implicitly a part of a firm’s top management functions but now the lines are being drawn a bit more sharply and the interaction of day to day sourcing activities with the strategic function has been more clearly spelt out. An indication of this trend in purchasing and outsourcing is the fact that many firms have strategic sourcing as an explicit part of the manufacturing strategy, with a designated (usually cross-functional) team to handle the activity. The following section elaborates this theme with the motivation drawn from the concept of a supply chain. SUPPLY CHAIN PERSPECTIVE ON MAKE OR BUY The make or buy decision of firms involved in the manufacture of complex products was founded first on the economics of producing the item, and then on the question of technological capability and competence. This takes care of the initial feasibility and the cost competitiveness of the operation from a competitive strategy point of view (Porter, 1985). The basic supply chain perspective adds the additional dimension of logistical ease in the context of other operations of the firm. An enhanced perspective arising from the same would involve other competitive factors such as quality and design, which have a subtle but important connection with the logistical flow of material. This is hinted at in another paper (Rangaraj, 1998) and is made more explicit later in this article. 4
  5. 5. At the simplest level, the make or buy decision in the supply chain context needs to be enhanced to include not only the single transaction of buying, but also the synchronisation costs with other activities. This is because buying involves loss of control of the scheduling and day to day control of activities. For example, the manufacture of a component may be brought in-house simply to avoid staging delays before assembly, even though an analysis of the cost of individual operations may not justify the manufacture in-house. In figure 1, we give a picture of the role of strategic sourcing vis-à-vis the supply chain imperatives of competitive manufacturing. This pattern is followed in some sense or other by a number of companies, where a materials department interacts in a cohesive manner with the strategic sourcing team, with the former taking care of day to day activities according to the norms and directions set by the latter. “Take in figure 1” IS ALL SOURCING ACTIVITY STRATEGIC? The first stage in formulating a firm’s supply strategy is often to classify all its purchased components and materials in terms of profit impact and supply risks into various categories. An example of this type of classification is shown in figure 2. The profit impact is determined on the basis of volume purchased, percentage of total purchased costs, and impact on product quality or business growth whereas supply risk is defined in terms of number of suppliers and substitution possibility. This classification is usually followed by an assessment of supplier’s and customer’s dependence on each other. “Take in figure 2” Depending on the buyer’s strength vis-à-vis the suppliers strength, Kraljic (Kraljic, 1983) has identified the basic ‘strategies’: exploit, diversify or balance. This is illustrated in 5
  6. 6. figure 3. The buyer firm can then identify areas of opportunity or vulnerability, assess supply risks and then derive basic sourcing policies for these items. We shall show that although each of the categories has an associated supplier strategy, it is only in quadrant IV that the full extent of strategic sourcing is visible. “Take in figure 3” For example, many small-scale suppliers may fall in the category ‘exploit’ (quadrant I), and the assembler (buyer) would normally concentrate on achieving favorable pricing and contract agreements. Though the company can bargain from a position of strength it may show preferential treatment to some suppliers, based on some past history of reliable supply. This is the only strategic part of this relationship. When the categorization indicates the ‘diversify’ option (quadrant III), the buyer firm is on the defensive and typically spends a lot of time looking for substitute materials or new suppliers. It may have to increase spending on market research, or even consider backward integration through major investment in R&D or production capacities. In short, the company needs supply options. As such, the relationship between the current supplier and buyer does not permit too much strategic leeway. For supply items with neither major visible risks nor major benefits, a defensive posture would be overconservative and costly. On the other hand, undue aggressiveness could damage supplier relations and lead to retaliation. In this case, a company should pursue a ‘balance(d)’ option (quadrant II), which indicates an uneasy relationship where no very positive actions can be expected. Therefore in none of these three cases is the supply relationship really of strategic significance of the type suggested by the marriage analogy in the beginning. 6
  7. 7. The fourth option When markets grow more dynamic and product innovation becomes important (as one of the consequences), there is a critical set of suppliers (and associated components) where the truly strategic part of the relationship matrix comes into play. This is quadrant IV in figure (3). Though Kraljic uses the term ‘balance’ even for this category, we suggest the ‘collaborate’ strategy in this quadrant. This is where the supply relationship acquires the maximum strategic significance. When companies talk about their strategic vendors and their partners in manufacturing, it is this class of vendors that they are really referring to. Strategies in action In the above figure we see that the quadrants I and III are inherently unstable as one or other of the partners seeks to move away from the relationship, if at all possible. Therefore in the long run, it is not surprising that the two balanced strategies (quadrants II and IV) are the ones that are most prevalent. Even within these balanced options, based on the level of outsourcing, a number of strategies can be observed in the case of automobile manufacturers with respect to foundries in India, as can be seen below. 1) Largely integrated, for example, TELCO [1]; 2) Joint ventures, for example, Ashok Leyland [1]; 3) Strategic relationships and joint investments, where for example, the car manufacturer, Maruti is reported to have a strong relationship with the foundry firm Menon & Menon and where Maruti has helped the latter in investment for setting up additional casting capacity for cylinder blocks [2]; 4) Purely market relationships, in the case of small, simple castings for which there are a number of suppliers and where the process/tooling is also not complicated. Shifts in supply-demand patterns can change a component's strategic category. For example, in case of an automobile assembler in Maharashtra, cylinder blocks and heads 7
  8. 8. have graduated from non-critical to strategic category because of frequent changes in the volumes required and design. Therefore this classification calls for regular updating. While individual components can be classified on the basis of their significance and criticality, at least one leading automobile assembler has started to define classes of components and subassemblies of strategic significance. For example, it has included castings as a key strategic class of components and systematically analyzed its own demand in terms of annual volumes and relative complexity of each type of casting. This assembler assessed, foundry by foundry, the capabilities of each potential supplier to decide the best match by comparing alternative supply scenarios . For example, there is an upheaval of sorts in the automobile industry, as far as the supply of critical items such as cylinder blocks. High quality suppliers in this segment are few, and their bargaining power is high. Partly because of this, one automobile assembler is spending a considerable amount of resources on R&D activities for developing aluminum cylinder blocks, moving away from regular gray iron cylinder blocks, whereas another auto maker is looking for new suppliers with advanced technology for cylinder blocks. In the case of electrical machinery, a more exhaustive study of supplier strategies can be found in (Humphrey, 1998). CONTENT OF STRATEGIC SOURCING A company needs to support sourcing decisions of strategic items with a number of analytical techniques, including marketing analysis, risk analysis, price forecasting and various microeconomic analyses. A more detailed look at these techniques can be seen, for example, in Kraljic (Kraljic, 1983) and other references which are more focused on purchasing strategy for different industrial sectors. In the rest of this section, we focus on the set of actions in the fourth quadrant, where companies are likely to invest the maximum managerial effort. 8
  9. 9. The strategic sourcing activity is part of the overall supply chain imperative of competitive manufacturing. Strategic sourcing consists of activities such as outsourcing decisions, structuring of the vendor base, vendor location, joint investment strategies, and so on. The following table (Table 1) lists some major initiatives in sourcing, which are derived from supply chain imperatives, and briefly indicates their impact on the competitive priorities of quality, design and logistics. This supplements the description of the technical and managerial actions in this regard, which has been dealt with separately in a companion paper (Rangaraj, 1998). “Take in table 1” Cross functional teams Typically, the actions described in the previous section are planned and executed by a ‘strategic sourcing team’ which essentially is a cross functional one. There are people from materials, quality assurance and finance departments along with manufacturing personnel in this team. Thus in the earlier step of supplier selection, they are not only exposed to technological (design and manufacturing) capability scrutiny but also to evaluation of quality systems and financial health. Even after selection, this team works and communicates closely with different functions on the supplier side on variety of issues, thus removing the organisational barriers and increasing the supply chain effectiveness. The interaction of a typical strategic sourcing team with the operational part of a company’s operations can be illustrated in the case of a particular competitive attribute such as quality as follows. It is the strategic sourcing team which would decide, based on company policy, to implement a certain quality system or quality standard such as QS 9000 (in the case of automobile vendors). This forms the backdrop against which the operational management of quality of vendor supplies takes place (see figure 1). In the case of quality, the devolution of the function is so important that a further tactical level of management is present in some companies to translate quality policy into achievable 9
  10. 10. objectives over a period of time. It is this intermediate level which will determine the way the relationships are built over a period of time to achieve strategic goals. This process (over time) oriented view of assembler supplier relationships is elaborated in the next section. EVOLUTION OF PARTNERSHIPS In this section we discuss how strategic partnerships between supplier and buyer evolve over time. We start with a recap of the reasons buyers and sellers enter into such partnerships in the first place. Buyer's and Supplier's Perspectives Our field study indicates that the two primary reasons that buyer firms enter partnerships are to obtain a better price or total cost for the purchased item and to secure a reliable source. This finding is in tune with (Prabhakar, 1996). Price/cost has long been a driving force [3] in traditional relationships, so it is not surprising that this is still a critical issue. Source reliability is a broad factor, which encompasses the idea of having an assured source of supply in times of scarcity, a source that will live up to its commitments and promises, and one that exhibits overall dependability. Again, it is not surprising that this was a very crucial factor in seeking out a long-term relationship with suppliers. The desire to initiate JIT; improving delivery schedules; reducing administrative procedures and costs of ordering, invoicing are the other reasons for buyers to enter partnerships. On the other hand, the number one reason that suppliers enter partnerships is to secure a reliable market for a given product. The desire to improve customer's quality, desire to influence/gain access to customer's technology were other issues. 10
  11. 11. Evolution of Long-Term Relationships There are difficulties in moving to a different style of supplier management. Some of these are infrastructural and some have to do with the status of suppliers and larger firms in India. These are as follows. 1) Large firms have been historically diverse in developing economies and tend to be vertically integrated. Starting with poor supplier infrastructure, there is low incentive to start co-operative relationships with such suppliers. 2) There is market reservation for some categories of items for Small Scale Industries (in India). This might be responsible for the lack of growth of small firms to good medium size firms. 3) There is lack of trust because of a history of commercial transactions and the reputation of large industry firms in this regard. 4) There is lack of commitment to principles such as total quality, on the part of suppliers. 5) In most of the literature available on this topic, poor communication is ranked as the most important cause of failure to move to the new different style for both the groups. Apart from such reasons, the following point emerges as a crucial one in determining the evolution of effective partnerships. There is a sharp line between what firms necessarily do on their own and where co-ordination is required. If an organisation is to be viewed as a structure which allows individuals to co-operate and reap the benefits of joint action, a supply chain can be viewed as a similar structure referring to firms in place of the individuals. However, just as individual responsibilities are important while being under the umbrella of an organisation, the role of each firm as a part of a supply chain interaction has to be well defined. These new roles will naturally take time to gain effective shape. 11
  12. 12. If we return to the marriage analogy referred to in the beginning, it is only when each partner is secure in its own identity, capabilities and actions that joint efforts will bear fruit. This is reflected further in the following section. Stages of Development in Supplier Relationships At this point in the discussion, we assume that the initial make or buy decision has been made and that the supplier has been identified. The general framework is for suppliers of typical engineering assembly components to industries such as white goods, automobiles or light machinery, but with some modifications, raw material or other suppliers can be analysed similarly. Service providers will require a different list, but based on the same principles. The other assumption is that the supplier activity is not so specialised that the technology is available only to that firm. The basic steps in the evolution of supplier relationships could be listed as the following : 1. Basic contract specified between the two parties [quantities, rates and period of contract]. Supplier provided with drawings and basic specifications only. 2. Critical parameters specified for incoming part quality. Aggregate production plans known to supplier. 3. Procedure for incoming quality inspection known to the supplier. Detailed production plans known in advance to the supplier. 4. Standardisation of quality procedures at the supplier’s dispatch and buyer (gauges, testing parameters etc.). Buyer is informed in upstream design and testing procedures of supplier, e.g. die design, patterns, tooling and raw materials. Supplier production constraints taken into account. 12
  13. 13. 5. Improvements initiated by buyer after an audit of supplier operations (this involves a certain amount of trust between the two). Such audits and supplier certification are often part of quality systems such as newer versions of ISO 9000 and other systems. 6. Improvements initiated by the supplier, with an implicit sharing of gains. This could include value engineering and better design for manufacture. 7. Common strategic planning of long term relationships spanning many contracts. A landmark in relations A key observation is that supplier responsibility in the chain (the market interaction) usually precedes the planned part (co-ordination) of the relationship. This is in contrast with the internal operations of a large firm, where after a planned effort at setting up operations, there are various measures taken to decentralise the control of operations. Between suppliers and buyers, this operational decentralisation has to be accompanied by a building up of trust. This trust is established as follows. Continued quality supply at controlled costs gives the buyer the confidence to shift quality assurance completely to the supplier end, where it is most effective. Such suppliers are typically classified as ‘self certified’ and supply directly to assembly lines or stores, without incoming inspection. They are typically subject only to random complete checks, such as skip lot inspection procedures (sometimes even conducted by third party inspection agencies, since the primary purpose is occasional monitoring), where failure means loss of self certification. Once this is accepted, then it can be inferred that by whatever means, the supplier is answerable for the basic process at its end. It then makes sense to talk of joint improvements, initiated by either party, long term plans and so on. Therefore, stage 4 in the previous section can be viewed as a landmark in relationship building, after which the action shifts to collaboration. Notice that by Stage 4, we indicate a technical basis for the capability not only from the supplier’s side but also the customer’s side, since the appropriate quality, logistical and design systems have to be in place. Effects at operational level 13
  14. 14. When strategic relationships emerge between firms and their foundry suppliers, the corresponding change in the operational parts of supply chain management can be clearly seen. For example, in India, what might have begun as an investment to assure supply of good quality castings (especially during the boom times of 94-95), soon translated into an opportunity to do better planning, cut supply chain inventories and improve designs and quality through more dedicated investments in tooling and patterns. Some foundries for the first time had the confidence and the security of orders to plan for improvements with a slightly larger horizon. A) For example, Maruti Udyog Limited (MUL) and Menon & Menon Limited (MML) share a good long term relationship. MUL gave advance payment to MML for setting up a dedicated line for increased volume of cylinder blocks for their 800 cc car (Prabhakar, 1996). By doing so there were many benefits - i. MUL was able to get timely deliveries which were not there earlier because of capacity constraints at MML (orders from different customers competed to get the priority). ii. From MML's point of view the scheduling/problem of assigning priorities to different customer orders was simplified. iii. Any change in MUL's production schedule was also responded to immediately, reducing supply chain inventories. iv. More frequent deliveries to MUL became possible. B) Target pricing is one of the joint actions possible as a result of close relationship and trust between a buyer and a supplier. This is exactly the opposite of the normal practice of a ‘cost-plus’ system where a profit percentage is added to all the cost components to arrive at the price. Here, both assembler and supplier mutually agree on a price (which is not unrealistic) which should be aimed at. The joint actions are taken to achieve this by identifying and attacking the areas of cost components where savings are possible through value engineering exercises. Though the cost structure of the supplier will be supplied to the customer, the latter does not use this information to exploit the supplier. Rather, it will protect the supplier interest by passing on some of the benefits to the supplier. 14
  15. 15. This type of pricing is done by the Japanese automobile giant, Toyota, in mutual understanding with some of its suppliers (Womack, 1990). This is theoretically possible only when the buyer and the supplier share good, long term relationship with each other and there is information exchange of even proprietary information. Such activity is desirable in enhancing the supply chain competitiveness as various links in the chain are working in co-operation with each other. There is sharing of the benefits and the risks as well. C) At the operational level, some other changes are also visible. e.g. for the first time, supplier firms are asked to specify process capabilities and parameters during the time of order finalisation, and any problems in supply have to be accompanied by documentation about the quality systems at the supplier’s end. D) The concept of ‘resident engineer’ (assembler's engineer staying at supplier's place and helping him out in solving the problems) is also coming up in a step towards ‘Quality at source’. However, in the light of the discussion in last two subsections, this device could lead to some passing of the buck as far as the supplier is concerned. At least one automobile assembler has started an aggressive plan to ensure supply as per agreed to specifications, and demanding acceptable quality supply, before getting into areas of joint problem solving with suppliers. A further dimension to this dynamic is the following. With increased competition in final markets, buyers and materials procurement personnel in the assemblers plants are not subjected only to volume and quantity pressures, but also to certifying quality. There is less of a temptation to pass on the responsibility of performance to downstream stages such as assembly and testing. Therefore, although objectives of material supply 15
  16. 16. departments may vary, the presence of strategic sourcing teams and monitoring of strategic objectives indicates that buyers are increasingly willing to take a longer term perspective of their interaction with suppliers. CONCLUSION To gain competitive advantages and develop a long term relationship with suppliers, buyers are having a very close look at their purchasing function. We see that strategic sourcing and partnerships are on the rise and this trend cuts across industrial sectors. This article presents a normative strategic sourcing methodology that suggests a route for firms to follow when seeking and developing partnerships. This step-by-step approach is based on a review of previous work on sourcing / partnerships, and on the study of experiences of the purchasing function of firms involved in such partnerships. The strategic sourcing methodology also represents a way for the purchasing function to improve its support of the supply chain's overall effectiveness. We think that strategic sourcing can be an important tool and will continue to receive a great deal of attention in the foreseeable futur e. REFERENCES Humphrey, J., Kaplinsky, R., and Saraph, P.V., with Chandrashekhar, T.S., Datta, R.C., and Rangaraj, N. (1998), Corporate Restructuring: Crompton Greaves and the Challenge of Globalisation, Sage Publications, New Delhi. 16
  17. 17. Kathuria, S. (1996), Competing through Technology and Manufacturing, Oxford University Press, New Delhi. Kraljic, P. (1983) “Purchasing Must Become Supply Management”, Harvard Business Review, Sep-Oct, pp. 109-117. Porter, M.E. (1985), Competitive Advantage, The Free Press, New York. Prabhakar, M., Seshan, S., Dutta, S., Ganguli, B. (1996) “A Vote for Vendors” Business India, Feb 26-Mar 10, pp. 160-162. Rangaraj, N., Ravi, B., Soman, C.A. (1998) “A Supply Chain Perspective on Initiatives in the Casting Industry”, Indian Foundry Journal, Vol 44 No 2, pp. TP15-TP22. Weber, C.A., Current, J.R., Benton, W.C. (1991) “Vendor Selection Criteria and Methods”, European Journal of Operations Research, Vol 50 No 1, pp. 2-18. Williamson, O.E. (1979) “The Transaction-cost economics : the governance of contractual relations”, Journal of Law and Economics, Vol 22, pp. 233-261. Womack, J.P., Jones, D.T., Roos, D. (1990), The Machine that Changed the World, Rawson associates, New York. ENDNOTES 17
  18. 18. [1] TELCO started its operations in Bihar, a relatively backward state in terms of industrialisation. At that time small scale industry in the state was in an infant stage of development and TELCO probably found it necessary to have foundry & forging facilities integrated with their assembly plant. Uncompromising quality standards, large volumes, and large investments required to achieve their projected growth plans were other factors which led TELCO to a large level of vertical integration. On the other hand, according to Kathuria, Ashok Leyland had a comparatively small volume/market share and could also be viewed as being comparatively low risk taking. They may have also been influenced by their collaborator (British Leyland) which does not have a high degree of integration. Ashok Leyland’s purchasing strategy appears to be of the arm's length variety at first sight, but in fact, it has followed a strategy of quasi- integration with Ennore Foundries (a high quality foundry) to supply it with automotive castings. Ennore Foundries is a joint venture in which Ashok Leyland has an equity share of 19.7%. Apart from this, Ashok Leyland places extensive reliance on outsourcing and the Small Scale Industry base. Since there is much less integration in Ashok Leyland, during a recessionary phase (which is being faced in 1997-1998) the cost per unit does not increase as much as TELCO even if there is under utilized capacity. [2] The robust explanation for this comes from the Transaction Cost Analysis (TCA) theory, which is credited to Oliver Williamson. TCA combines economic theory with management theory to determine the best type of relationship a firm shall develop in the marketplace. The reasoning concludes that an optimal management decision is dependent on the transaction costs associated with various alternatives (Williamson, 1979). The level of transaction costs in a specific case depends on a number of factors: such as frequency of transaction; level of transaction specific investments (asset specificity); and external and internal uncertainty. According to TCA theory, partnering works best in cases where there is some degree of asset specificity, transactions are recurrent (only recurring transactions are of interest here because partnering represents an ongoing relationship) , and there is a degree of uncertainty in the environment. In this case transaction specific investments are the assets dedicated to a particular relationship that may be difficult to replace (from Maruti's perspective) or redeploy (from Menon and Menon's perspective). 18
  19. 19. [3] A survey article (Weber, 1991) reviews 74 articles on criteria used in the vendor selection process since 1966. Though quality and delivery are gaining more importance, price appears to be a critical issue throughout these years. 19
  20. 20. Table 1: Strategic sourcing initiatives and their impact on competitive priorities Strategic sourcing Competitive priorities Quality Design Logistics initiative Single/dual sourcing Traceability, Standardized design Transport/order scale Accountability procedures possible economies, Information sharing Persuading suppliers to locate Quick feedback and Design teams Lower costs, close to customers improvements Possible Pull system possible Encouraging suppliers to Ensuring quality at Integrated design Smaller and more reliable vertically integrate some source is easier changes possible lead times operations Quasi integration (Financial More influence on Collaborative efforts to Pull system possible support to, or equity in suppliers) choice of quality improve designs systems possible Tiering of suppliers Performance of Higher level design Co-ordination easier subassemblies changes possible 20 20