Outsourcing

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					               Outsourcing
• An “easy way” to increase profits
• Nike, Cisco, Apple outsource most of their
  manufacturing
  – Each could focus on research, marketing
  – Each has gotten into trouble
     • 2001 – Nike reported unexpected profit shortfalls due
       to inventory problems
     • 2000 – Cisco had to write down billions in obsolete
       inventory
     • 1999 – Apple was unable to meet customer demand
       for new products
Outsourcing Benefits and Risks
• Benefits
  – Economies of scale reduce manufacturing costs
  – Risk pooling – demand uncertainties are
    transferred
  – Reduced capital investment
  – Focus on core competencies
  – Increased flexibility
• Risks
  – Loss of competitive knowledge
  – Conflicting objectives
     • Flexibility vs. long-term, stable commitments, etc.
• Consider the IBM PC example.
 A Framework for Outsourcing
• Reasons for outsourcing
  – Dependency on capacity
  – Dependency on knowledge
• Product architecture
  – Integral products – components are tightly
    related
     • Designed as a system
     • Not off-the-shelf components
     • Evaluated based on system performance
  – Modular products –independent components
    A Framework for Outsourcing
              (Fine & Whitney)


Product Dependent: Indep:         Indep.:
        knowledge, knowledge      knowledge
        capacity    Dep:          capacity
                    capacity
Modular Outsourcing Outsourcing  Outsourcin
        risky       opportunity  g can
                                 reduce cost
Integral Outsourcing Outsourcing Keep
         very risky  option      internal
The Move to B2B Commerce
                                   B2B is Huge...

            Business-to-Consumer                      2003
            Business-to-Business                   $1.3 Trillion



                                            2002
                                           $843B



                                    2001
                  1999             $499B
       1998      $109B
       $43B
                        2000
                       $251B



Source: Forrester Research, Inc.
       FreeMarkets Online
• FreeMarkets is an online market making
  firm that enabled industrial buyers to link
  up with their potential suppliers in a live
  electronic bidding
• The end result of such interaction among
  a network of suppliers was procurement
  cost savings of about 15% for the buyers
• The company was founded in 1995 and
  was on the verge of breaking even in 1998
  – It was expecting to receive commissions and
    fees of nearly $6 million for arranging
    procurement of ~$200 million worth of
    industrial components and parts
The company went public in
        12/99...

        Freemarket’s Stock Price
    Where is FreeMarkets
           today?
• For the three months ended in
  3/31/01
  – Revenue totaled $33M
  – Net loss totaled $43.7M
• For the three months ended in
  12/31/01
  – Revenue totaled $44.8M
  – Net loss totaled $2.8M
          Highly Fragmented
• Most product categories are highly fragmented,
  with numerous suppliers each offering different
  level of quality, service and pricing options
• Buyers incur significant cost in the actual
  purchase process
   – A buyer must invest internal resources to manage the
     process of collecting, analyzing and acting upon all the
     information in the market
   – In addition to purchase price companies spend over
     10% in additional procurement costs
• On the suppliers side, there are significant costs
  in using the manufacturing reps
   – These commissions range from 4% to 7% of purchase
     price
How Does FreeMarkets Online Create
     Value for its Customers?
• Consulting/Purchase outsourcing
  – Putting together specs, drawings, lot
    sizes, documentation and RFQs
  – Identifying potential savings
    opportunities
  – Identifying and qualifying suppliers
  – Educating and training buyers
  – Conducting the Competitive Bidding
    Event (CBE)
  – Providing post bid analysis and support
How Does FreeMarkets Online Create
     Value for its Customers?
• Consulting/Purchase outsourcing
• Distribution Intermediary
Traditional B2B Trading
       Exchanges

              Industrial Buyer



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



Supplier 1        Supplier 2     Supplier 3
Internet Based B2B Trading
         Exchanges

               Industrial Buyer



               FreeMarkets Online



  Supplier 1       Supplier 2       Supplier 3
How Does FreeMarkets Online Create
     Value for its Customers?
• Consulting/Purchase outsourcing
• Distribution Intermediary
• Network Enabler/Software Provider
 What are the Barriers for the
           buyers?
• Elimination of established
  relationships with the suppliers and
  their representatives
• Elimination of manufacturing reps
  could result in loss of convenience
    What is the value to the
           suppliers?
• Less value for the suppliers
  – Commission costs fell from 7% to 2.5%
  – Table 7.5 implies reduction in
    commission by $174M(4.5%)=$8M
  – Table 7.5 also shows $35M drop in
    revenue for the suppliers
• Suppliers could benefit from lower
  sales, marketing and distribution
  costs and better utilization of
  capacity
      The Revenue Model
• A hybrid of service fees and sales
  commissions
  – FreeMarkets charged monthly fee from
    the buyer based on the size of the
    market making team dedicated to the
    event
  – Winning supplier paid sales
    commissions; this was paid in
    installments as suppliers shipped
    products
   Problems with the revenue
            model
• Buyer side:
  – FreeMarkets invests substantially in a project
  – Consulting revenue is independent of the value created
  – Does not lead to another intensive purchasing study for
    the customer
  – Gross margin on consulting is about 22%
  – Doesn’t scale well
• Supplier side:
  – FreeMarkets does not represent the supplier
  – FreeMarkets success depends on their ability to identify
    many potential suppliers
  – Suppliers pay commissions to the company that reduced
    their margins
     Vertical vs Horizontal
             Focus?
• Vertical:
  – Advantage: FreeMarkets can capitalize
    on its deep knowledge of supplier
    industries
  – Disadvantage: Hard to scale-up
• Horizontal:
  – Advantage: Ability to generate multiple
    contracts from one buyers
  – Disadvantage: FreeMarkets does not
    bring much expertise to the transaction
   How about licensing the
        technology?
• Are buyers capable of using the
  technology by themselves?
• If not, how will this hurt?
• If they are, where is revenue going
  to come from?
• How can these problems be
  addressed?
     By the end of 1998…
• FreeMarkets was pursuing the
  horizontal market expansion
• In 2000, the company started
  licensing its software
   E-Marketplaces: The Initial
    (95-99) business model
• The e-marketplace concept started as a
  new way to procure products, particularly
  non-production items. E-marketplaces
  – Expand everyone’s market reach
  – Generate lower price for the buyers
  – Cut operational costs for buyers and suppliers
• Automating the procurement process will
  reduce processing cost per order from as
  high as $150 to as low as $5 per order
  – Focus on liquidity
  – Transaction fee paid by the suppliers
  – Serve as a virtual distributor
  Problems with this Business
            Model
• Sellers resist paying a fee to the company
  whose main objective is to reduce the
  purchase price
• Buyers resist paying a fee
• The revenue model needs to be flexible
  – Sometimes the wrong party is charged
• Low barriers to entry created a
  fragmented industry flooded with
  participants
  – Just in the chemical industry there were about
    30 e-markets
  Continuous evolution of the
        business model
• Transaction fees (typically paid by
  the sellers)
  – Sometimes the wrong party is charged
  – Buyers and suppliers resist paying
• Subscription fees (typically paid by
  the buyer)
  – Depends on a number of dimensions
• Licensing the software
    Evolving Market Types
• Value-added independent e-markets
  – They are expanding their offering to
    include inventory management and
    financial services (Zoho); supply chain
    planning (Covisint, e2open, Converge,
    TheSupply)
          A Framework for
           eProcurement
• Type of Component
  – Strategic Components
     • Part of the finished product
     • Not industry specific; company specific
     • Examples: PC motherboard and chassis
  – Commodity Products
     • Can be purchased from a large number of suppliers
     • Price is determined by market forces
     • Examples: Memory unit in a PC
  – Indirect Material
     • MRO
        A Framework for
         eProcurement
• Level of Risk
  – Uncertain Demand (Inventory risk)
  – Volatile market price (Price Risk)
  – Component availability (Shortage Risk)
 Risk: Commodity Products
• Can be purchased either
  – in the open market through on-line
   auction, or
  – through the use of long term contracts
• Long term contracts guarantee
  certain level of supply but may be
  risky for the buyer
  – Inventory risk, shortage risk or price
    risk
        A Framework for
         eProcurement
• Indirect Material
  – Typically low risk and hence the focus is
    on content based hubs.
  – The objective is to use an MRO-hub that
    specializes in unifying catalogs from
    many suppliers
  – Examples: MRO.com, Grainger on-line
    catalogs
               Grainger
• W. W. Grainger has been selling industrial
  supplies for 72 years
• In 1995 Grainger established
  Grainger.com, an on-line catalogue for
  more than 220,000 products from 12,000
  suppliers
• In 1999, Grainger experienced revenue
  growth of $102M through its internet
  channel
• The MRO supply industry is growing at a
  rate of 3-4% a year. From 1996 to 1999
  Grainger internet sales grew 32% a year
  and 20% in offline due to customers that
  were lured to Grainger from the web site
        A Framework for
         eProcurement
• Strategic Components
  – Typically high risk components that can
    be purchased from a small number of
    suppliers
  – The objective is to use private or
    consortia-based e-marketplace.
  – The focus is on an e-marketplace that
    allow collaboration with the suppliers
     Consortia or Private?
• Transaction volume
• Number of suppliers
• Cost of building and maintaining the
  site
• The importance of protecting
  proprietary business practices
• Technology and product life cycles
           A Framework for
            eProcurement
• Commodity Products
  – Products go directly into finished goods
     • High risk
  – Many potential options to choose from
  – Long Term Contracts
     • Buyer and supplier commit to certain volume (called the
       commitment level)
     • Supplier guarantees a level of supply for a committed price
  – Flexible, or Option Contracts
     • Buyer pre-pay a relatively small fraction of the product
       price up-front, in return for a commitment from the
       supplier to satisfy demand up to a certain level (called the
       option level)
     • The buyer can purchase any amount up to the option level
       by paying additional price for each unit purchased
  – Spot Purchasing
A Framework for eProcurement:                          A
     Portfolio Approach
     Option Level


      H

                 Inventory
                   Risk            N/A
                    (Supplier)

                Price, Shortage   Inventory
                     Risks          Risk
      L               (Buyer)      (Buyer)        Commitment
                                                    Level
            L                                 H
   B2B Software Vendors
• Oracle (Indirect and Direct)
• i2 Technologies and Manugistics
  (Direct)
• Ariba (Indirect and Direct)
• Commerce One (Indirect and Direct)
• Agile (Direct)
• VerticalNet (Indirect)
E-Procurement: The reality
• Companies conducting greater than
  20% of procurement transactions
  online have reduced their transaction
  processing cost by nearly a third
  (Hackett Benchmarking)
• Product savings and process cost
  improvements effect operating cost
  by 10% (Credit Suisse First Boston
  Technology Group)
E-Procurement: The reality
• To capture this benefits purchasing
  organization needs to invest heavily
  in:
  – Changing internal procurement
    processes
  – Integrating e-marketplaces in internal
    systems
  – Purchasing B2B applications, and
  – Paying e-marketplace transaction
 Source: Forrester Research
    fee/subscription fee
  Positive Aspects of Trading Exchanges
    (Companies who use exchanges):

• Reduce costs or labor (31%)
• Better access to products/vendors
  (24%)
• Increase speed or efficiency (29%)
• Access to more customers (21%)



   Source: AMR Research
Positive Aspects of Trading Exchanges
     (Companies who plan to use
             exchanges):
• Reduce costs or labor (43%)
• Better access to products/vendors
  (26%)
• Increase speed or efficiency (23%)
• Access to more customers (10%)
•

   Source: AMR Research
  Negative Aspects of Trading Exchanges
      (Companies use exchanges):

• Security trust (17%)
• Start Up cost (5%)
• Loss of face-to-face relationships
  (12%)
• Lack of standards (5%)
• Immature technology (5%)
• Integration issues (7%)
• Source: AMR Research
Negative Aspects of Trading Exchanges
    (Companies who plan to use
            exchanges):
• Security trust (16%)
• Start Up cost (15%)
• Loss of face-to-face relationships
  (11%)
• Lack of standards (6%)
• Immature technology (6%)
• Integration issues (4%)
• Pricing pressure (6%)

    Source: AMR Research