Discussion 3

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Sourcing Decisions in a Supply Chain

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Chopra and Meindl Supply Chain Management, 5e

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Learning Objectives

Understand the role of sourcing in a supply chain

Discuss factors that affect the decision to outsource a supply chain function

Identify dimensions of supplier performance that affect total cost

Structure successful auctions and negotiations

Describe the impact of risk sharing on supplier performance and information distortion

Design a tailored supplier portfolio

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The Role of Sourcing in a Supply Chain

Sourcing is the set of business processes required to purchase goods and services

Outsourcing

Offshoring

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The Role of Sourcing in a Supply Chain

Outsourcing questions

Will the third party increase the supply chain surplus relative to performing the activity in-house?

How much of the increase in surplus does the firm get to keep?

To what extent do risks grow upon outsourcing?

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The Role of Sourcing in a Supply Chain

Figure 15-1

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Supplier Scoring and Assessment

Supplier performance should be compared on the basis of the supplier’s impact on total cost

There are several other factors besides purchase price that influence total cost

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Supplier Selection

Identify one or more appropriate suppliers

Contract should account for all factors that affect supply chain performance

Should be designed to increase supply chain profits in a way that benefits both the supplier and the buyer

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Design Collaboration

About 80% of the cost of a product is determined during design

Suppliers should be actively involved at this stage

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Procurement

A supplier sends product in response to orders placed by the buyer

Orders placed and delivered on schedule at the lowest possible overall cost

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Sourcing Planning and Analysis

Analyze spending across various suppliers and component categories

Identify opportunities for decreasing the total cost

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Cost of Goods Sold

Cost of goods sold (COGS) represents well over 50 percent of sales for most major manufacturers

Purchased parts a much higher fraction than in the past

Companies have reduced vertical integration and outsourced

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Benefits of Effective Sourcing Decisions

Better economies of scale through aggregated

More efficient procurement transactions

Design collaboration can result in products that are easier to manufacture and distribute

Good procurement processes can facilitate coordination with suppliers

Appropriate supplier contracts can allow for the sharing of risk

Firms can achieve a lower purchase price by increasing competition through the use of auctions

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In-House or Outsource

Increase supply chain surplus through

Capacity aggregation

Inventory aggregation

Transportation aggregation by transportation intermediaries

Transportation aggregation by storage intermediaries

Warehousing aggregation

Procurement aggregation

Information aggregation

Receivables aggregation

Relationship aggregation

Lower costs and higher quality

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Factors Influencing Growth of Surplus by a Third Party

Scale

Large scale it is unlikely that a third party can achieve further scale economies and increase the surplus

Uncertainty

If requirements are highly variable over time, third party can increase the surplus through aggregation

Specificity of assets

If assets required are specific to a firm, a third party is unlikely to increase the surplus

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Factors Influencing Growth of Surplus by a Third Party

		Specificity of Assets Involved in Function
		Low	High
Firm scale	Low	High growth in surplus	Low to medium growth in surplus
	High	Low growth in surplus	No growth in surplus unless cost of capital is lower for third party
Demand uncertainty for firm	Low	Low to medium growth in surplus	Low growth in surplus
	High	High growth in surplus	Low to medium growth in surplus

Table 15-1

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Risks of Using a Third Party

The process is broken

Underestimation of the cost of coordination

Reduced customer/supplier contact

Loss of internal capability and growth in third-party power

Leakage of sensitive data and information

Ineffective contracts

Loss of supply chain visibility

Negative reputational impact

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Third- and Fourth-Party Logistics Providers

Third-party logistics (3PL) providers performs one or more of the logistics activities relating to the flow of product, information, and funds that could be performed by the firm itself

A 4PL (fourth-party logistics) designs, builds and runs the entire supply chain process

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Third- and Fourth-Party Logistics Providers

Service Category	Basic Service	Some Specific Value-Added Services
Transportation	Inbound, outbound by ship, truck, rail, air	Tendering, track/trace, mode conversion, dispatch, freight pay, contract management
Warehousing	Storage, facilities management	Cross-dock, in-transit merge, pool distribution across firms, pick/pack, kitting, inventory control, labeling, order fulfillment, home delivery of catalog orders
Information technology	Provide and maintain advanced information/computer systems	Transportation management systems, warehousing management, network modeling and site selection, freight bill payment, automated broker interfaces, end-to-end matching, forecasting, EDI, worldwide track and trace, global visibility
Reverse logistics	Handle reverse flows	Recycling, used-asset disposition, customer returns, returnable container management, repair/refurbish
Other 3PL services		Brokering, freight forwarding, purchase-order management, order taking, loss and damage claims, freight bill audits, consulting, time-definite delivery
International		Customs brokering, port services, export crating, consolidation
Special skills/handling		Hazardous materials, temperature controlled, package/parcel delivery, food-grade facilities/equipment, bulk

Table 15-2

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Using Total Cost to Score and Assess Suppliers

Performance Category	Category Components	Quantifiable?
Supplier price	Labor, material, overhead, local taxes, and compliance costs	Yes
Supplier terms	Net payment terms, delivery frequency, minimum lot size, quantity discounts	Yes
Delivery costs	All transportation costs from source to destination, packaging costs	Yes
Inventory costs	Supplier inventory, including raw material, in process and finished goods, in-transit inventory, finished goods inventory in supply chain	Yes
Warehousing cost	Warehousing and material handling costs to support additional inventory	Yes
Quality costs	Cost of inspection, rework, product returns	Yes
Reputation	Reputation impact of quality problems	No
Other costs	Exchange rate trends, taxes, duties	Yes
Support	Management overhead and administrative support	Difficult
Supplier capabilities	Replenishment lead time, on-time performance, flexibility, information coordination capability, design coordination capability, supplier viability	To some extent

Table 15-3

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Comparing Suppliers Based on Total Cost

Annual material cost = 1,000 x 52 x 1 = $52,000

Average cycle inventory = 2,000/2 = 1,000

Annual cost of holding cycle inventory = 1,000 x 1 x 0.25 = $250

Standard deviation of ddlt =

Safety inventory required with current supplier =

Annual cost of holding safety inventory = 1,787 x 1 x 0.25 = $447

Annual cost of using current supplier = 52,000 + 250 + 447 = $52,697

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Annual material cost = 1,000 x 52 x 0.97 = $50,440

Average cycle inventory = 8,000/2 = 4,000

Annual cost of holding cycle inventory = 4,000 x 0.97 x 0.25 = $970

Standard deviation of ddlt =

Safety inventory required with current supplier =

Annual cost of holding safety inventory = 6,690 x 0.97 x 0.25 = $1,622

Annual cost of using current supplier = 50,440 + 970 + 1,622 = $53,032

Comparing Suppliers Based on Total Cost

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Supplier Selection – Auctions and Negotiations

Supplier selection can be performed through competitive bids, reverse auctions, and direct negotiations

Supplier evaluation is based on total cost of using a supplier

Auctions:

Sealed-bid first-price auctions

English auctions

Dutch auctions

Second-price (Vickery) auctions

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Supplier Selection – Auctions and Negotiations

Factors influence the performance of an auction

Is the supplier’s cost structure private (not affected by factors that are common to other bidders)?

Are suppliers symmetric or asymmetric; that is, ex ante, are they expected to have similar cost structures?

Do suppliers have all the information they need to estimate their cost structure?

Does the buyer specify a maximum price it is willing to pay for the supply chain?

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Supplier Selection – Auctions and Negotiations

Collusion among bidders

Second-price auctions are particularly vulnerable

Can be avoided with any first-price auction

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Basic Principles of Negotiation

The difference between the values of the buyer and seller is the bargaining surplus

The goal of each negotiating party is to capture as much of the bargaining surplus as possible

Have a clear idea of your own value and as good an estimate of the third party’s value as possible

Look for a fair outcome based on equally or equitably dividing the bargaining surplus

A win-win outcome

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Contracts, Risk Sharing, and Supply Chain Performance

How will the contract affect the firm’s profits and total supply chain profits?

Will the incentives in the contract introduce any information distortion?

How will the contract influence supplier performance along key performance measures?

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Contracts for Product Availability and Supply Chain Profits

Independent actions taken by two parties in a supply chain often result in profits that are lower than those that could be achieved if the supply chain were to coordinate its actions

Three contracts that increase overall profits by making the supplier share some of the buyer’s demand uncertainty are

Buyback or returns contracts

Revenue-sharing contracts

Quantity flexibility contracts

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Buyback Contracts

Allows a retailer to return unsold inventory up to a specified amount at an agreed upon price

The manufacturer specifies a wholesale price c and a buyback price b

The manufacturer can salvage $sM for any units that the retailer returns

The manufacturer has a cost of v per unit produced and the retail price is p

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Buyback Contracts

Wholesale Price c	Buyback Price b	Optimal Order Size for Music Store	Expected Profit for Music Store	Expected Returns to Supplier	Expected Profit for Supplier	Expected Supply Chain Profit
$5	$0	1,000	$3,803	120	$4,000	$7,803
$5	$2	1,096	$4,090	174	$4,035	$8,125
$5	$3	1,170	$4,286	223	$4,009	$8,295
$6	$0	924	$2,841	86	$4,620	$7,461
$6	$2	1,000	$3,043	120	$4,761	$7,804
$6	$4	1,129	$3,346	195	$4,865	$8,211
$7	$0	843	$1,957	57	$5,056	$7,013
$7	$4	1,000	$2,282	120	$5,521	$7,803
$7	$6	1,202	$2,619	247	$5,732	$8,351

Table 15-4

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Buyback Contracts

Holding-cost subsidies

Manufacturers pay retailers a certain amount for every unit held in inventory over a given period

Encourage retailers to order more

Price support

Manufacturers share the risk of product becoming obsolete

Guarantee that in the event they drop prices they will lower prices for all current inventories

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Revenue-Sharing Contracts

Manufacturer charges the retailer a low wholesale price c and shares a fraction f of the retailer’s revenue

Allows both the manufacturer and retailer to increase their profits

Results in lower retailer effort

Requires an information infrastructure

Information distortion results in excess inventory in the supply chain and a greater mismatch of supply and demand

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Revenue-Sharing Contracts

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Revenue-Sharing Contracts

Wholesale Price c	Revenue-Sharing Fraction f	Optimal Order Size for Music Store	Expected Overstock at Music Store	Expected Profit for Music Store	Expected Profit for Supplier	Expected Supply Chain Profit
$1	0.30	1,320	342	$5,526	$2,934	$8,460
$1	0.45	1,273	302	$4,064	$4,367	$8,431
$1	0.60	1,202	247	$2,619	$5,732	$8,350
$2	0.30	1,170	223	$4,286	$4,009	$8,295
$2	0.45	1,105	179	$2,881	$5,269	$8,150
$2	0.60	1,000	120	$1,521	$6,282	$7,803

Table 15-5

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Quantity Flexibility Contracts

Allows the buyer to modify the order (within limits) after observing demand

Better matching of supply and demand

Increased overall supply chain profits if the supplier has flexible capacity

Lower levels of information distortion than either buyback contracts or revenue sharing contracts

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Quantity Flexibility Contracts

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Quantity Flexibility Contracts

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Quantity Flexibility Contracts

a	b	Wholesale Price c	Order Size O	Expected Purchase by Retailer	Expected Sale by Retailer	Expected Profits for Retailer	Expected Profits for Supplier	Expected Supply Chain Profit
0.00	0.00	$5	1,000	1,000	880	$3,803	$4,000	$7,803
0.05	0.05	$5	1,017	1,014	966	$4,038	$4,004	$8,416
0.20	0.20	$5	1,047	1,023	967	$4,558	$3,858	$8,416
0.00	0.00	$6	924	924	838	$2,841	$4,620	$7,461
0.20	0.20	$6	1,000	1,000	955	$3,547	$4,800	$8,347
0.30	0.30	$6	1,021	1,006	979	$3,752	$4,711	$8,463
0.00	0.00	$7	843	843	786	$1,957	$5,056	$7,013
0.20	0.20	$7	947	972	936	$2,560	$5,666	$8,226
0.40	0.40	$7	1,000	1,000	987	$2,873	$5,600	$8,473

Table 15-6

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Contracts to Coordinate Supply Chain Costs

Differences in costs at the buyer and supplier can lead to decisions that increase total supply chain costs

A quantity discount contract may encourage the buyer to purchase a larger quantity which would result in lower total supply chain costs

Quantity discounts lead to information distortion because of order batching

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Contracts to Increase Agent Effort

In many supply chains, agents act on behalf of a principal and the agents’ efforts affect the reward for the principal

A two-part tariff offers the right incentives for the dealer to exert the appropriate amount of effort

Threshold contracts increase information distortion

Offer threshold incentives over a rolling horizon

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Contracts to Induce Performance Improvement

A buyer may want performance improvement from a supplier who otherwise would have little incentive to do so

A shared-savings contract provides the supplier with a fraction of the savings that result from performance improvement

Effective in aligning supplier and buyer incentives when the supplier is required to improve performance and most of the benefits of improvement accrue to the buyer

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Design Collaboration

50-70% of spending at a manufacturer comes from procurement

80% of the cost of a purchased part is fixed in the design phase

Design collaboration with suppliers can result in reduced cost, improved quality, and decreased time to market

Design for logistics, design for manufacturability

Modular, adjustable, dimensional customization

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The Procurement Process

The process in which the supplier sends product in response to orders placed by the buyer

Main categories of purchased goods

Direct materials

Indirect materials

Procurement process for direct materials should be designed to ensure that components are available in the right place, in the right quantity, and at the right time

Focus for indirect materials should be on reducing transaction cost

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Differences Between Direct and Indirect Materials

	Direct Materials	Indirect Materials
Use	Production	Maintenance, repair, and support operations
Accounting	Cost of goods sold	Selling, general, and administrative expenses (SG&A)
Impact on production	Any delay will delay production	Less direct impact
Processing cost relative to value of transaction	Low	High
Number of transactions	Low	High

Table 15-7

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Product Categorization

Figure 15-2

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Designing a Sourcing Portfolio: Tailored Sourcing

Options with regard to whom and where to source from

Produce in-house or outsource to a third party

Will the source be cost efficient or responsive

Onshoring, near-shoring, and offshoring

Tailor supplier portfolio based on a variety of product and market characteristics

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Designing a Sourcing Portfolio: Tailored Sourcing

	Responsive Source	Low-Cost Source
Product life cycle	Early phase	Mature phase
Demand volatility	High	Low
Demand volume	Low	High
Product value	High	Low
Rate of product obsolescence	High	Low
Desired quality	High	Low to medium
Engineering/design support	High	Low

Table 15-8

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Designing a Sourcing Portfolio: Tailored Sourcing

	Onshore	Near-shore	Offshore
Rate of innovation/product variety	High	Medium to High	Low
Demand volatility	High	Medium to High	Low
Labor content	Low	Medium to High	High
Volume or weight-to-value ratio	High	High	Low
Impact of supply chain disruption	High	Medium to High	Low
Inventory costs	High	Medium to High	Low
Engineering/management support	High	High	Low

Table 15-9

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Risk Management in Sourcing

Inability to meet demand on time

An increase in procurement costs

Loss of intellectual property

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Making Sourcing Decisions in Practice

Use multifunction teams

Ensure appropriate coordination across regions and business units

Always evaluate the total cost of ownership

Build long-term relationships with key suppliers

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Summary of Learning Objectives

Understand the role of sourcing in a supply chain

Discuss factors that affect the decision to outsource a supply chain function

Identify dimensions of supplier performance that affect total cost

Structure successful auctions and negotiations

Describe the impact of risk sharing on supplier performance and information distortion

Design a tailored supplier portfolio

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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher.

Printed in the United States of America.

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2×3002 +1,0002 ×12 =1,086.28

2´300

+1,000

´1

=1,086.28

NORMSINV(0.95)×1,086.28 =1,787

NORMSINV(0.95)´1,086.28=1,787

6×3002 +1,0002 ×42 = 4,066.94

6´300

+1,000

´4

=4,066.94

NORMSINV(0.95)×4,066.94 = 6,690

NORMSINV(0.95)´4,066.94=6,690

Expected manufacturing profit =O * (c – v) – (b – sM )

Expected manufacturing profit =O*(c–v)–(b–s

)

× expected overstock at retailer

´ expected overstock at retailer

CSL* = probability (demand ≤O*) = Cu

Cu +Co =

(1– f )p – c (1– f )p – sR

CSL*=probability (demand £O*)=

(1–f)p–c

(1–f)p–s

Expected manufacturers profits = (c – v)O *

Expected manufacturers profits=(c–v)O*

+ fp(O * – expected overstock at retailer)

+fp(O*– expected overstock at retailer)

Expected retailer profit

+sR × expected overstock at retailer – cO *

´ expected overstock at retailer–cO*

= (1– f )p(O * – expected overstock at retailer)

=(1–f)p(O*– expected overstock at retailer)

Expected quantity purchased by retailer, QR

Expected quantity purchased by retailer, Q

= qF(q)+Q 1– F(Q)⎡⎣ ⎤⎦

=qF(q)+Q1–F(Q)

+µ Fs Q – µ σ

⎛

⎝ ⎜

⎞

⎠ ⎟– Fs

q– µ σ

⎛

⎝ ⎜

⎞

⎠ ⎟

⎡

⎣ ⎢

⎤

⎦ ⎥

+mF

Q–m

–F

q–m

= –σ fs Q – µ σ

⎛

⎝ ⎜

⎞

⎠ ⎟– fs

q– µ σ

⎛

⎝ ⎜

⎞

⎠ ⎟

⎡

⎣ ⎢

⎤

⎦ ⎥

=–sf

Q–m

–f

q–m

Expected quantity sold by retailer, DR

Expected quantity sold by retailer, D

= Q 1– F(Q)⎡⎣ ⎤⎦

=Q1–F(Q)

+µFs Q – µ σ

⎛

⎝ ⎜

⎞

⎠ ⎟–σ fs

q– µ σ

⎛

⎝ ⎜

⎞

⎠ ⎟

+mF

Q–m

–sf

q–m

Expected quantity overstock at manufacturer

Expected quantity overstock

at manufacturer

Expected retailer profit = DR × p+ QR – DR( )sR – QR ×c

Expected retailer profit=D

´p+Q

–D

( )

–Q

´c

Expected manufacturer profit = QR ×c+ Q – QR( )sM – Q×v

Expected manufacturer profit =Q

´c+Q–Q

( )

–Q´v

= QR – DR

–D