Supply Chain

Management
Module-2
 Content
• Strategic Sourcing Outsourcing – Make Vs buy - Identifying
core processes - Market Vs Hierarchy - Make Vs buy
continuum -Sourcing strategy - Supplier Selection and
Contract Negotiation. Creating a world class supply base-
Supplier Development - World Wide Sourcing.
 Introduction: Make Versus Buy
• The decision of a firm to perform its activities internally or
get those activities done from an independent firm is known
as the make versus buy decision. It involves the following key
decisions:
• What activities should be carried out by the firm and what
activities should be outsourced?
• How to select the entities/partners to carry out outsourced
activities and what should be the nature of the relationship
with those entities?
• Should the relationship be transactional in nature or should
it be a long-term partnership?
 Make Versus Buy: Strategic
Approach
• we classify all supply chain activities as primary activities and support
activities.

• Primary activities consist of inbound logistics, operations, outbound

logistics, sales and service.
• Secondary activities involve procurement, technology development,
human resource management and firm infrastructure management.
• The make versus buy decisions look at each of these activities
critically and ask the question:
• Should this activity be done internally or can it be outsourced to an
external party? Once the decision to outsource has been taken, the
firm has to choose among competing suppliers and also decide on the
nature of the relationship it would like to establish with the supplier
firm.
 Bharti Airtel: Outsourcing of
Network Operations
• Network Management to Ericsson, Nokia and Siemens

• IT Management to IBM

• Customer service call centers to Hinduja TMT, Mphasis, IBM Daksha

and Teletech India
 Identifying Core Processes

• As exemplified by Bharti Airtel, the decision to identify selected

processes as core processes and focus on improving those can have a
significant impact on the performance of a firm. The identification of
core processes is a crucial decision.
 Microsoft’s Entry Into Video
Game Business
• When Microsoft decided to get into the business of video games in
the mid-1990s, it decided that it would not carry out manufacturing
and distribution activities in-house.
• Microsoft wanted to ensure that the Xbox was on the retailers’
shelves in October 2001 and was sold for $400.
• Microsoft was very clear that it would focus only on the software part
of the Xbox and leave the hardware design and manufacturing to
Flextronics, a large electronics manufacturing service provider
 The Business Process Route
• For any firm, three core and high-level business processes include

• Customer Relationship,

• Product Innovation

• Supply Chain Management.

• Customer relationship focuses on acquiring new customers and
building relationships with existing customers.

• Product innovation focuses on developing new products and services.

• While supply chain management focuses on fulfilment of customer

orders.
• It is possible to un-bundle the three business processes and a firm can
afford to outsource two of these business processes.
• Some researchers have argued that a firm must identify and ensure that it builds
core capabilities in-house in at least one of these areas.
• Firms like HP and high-end pharmaceutical firms focus on product innovations.
Firms like Nike and Benetton focus on brand building and customer relationships.
• Firms like Wal-Mart and Dell Computers focus on supply chain management
capabilities. Of course, within the identified core business process, firms can
examine each of the activity and probably outsource those activities that are of
the commodity type.
• For example, within supply chain management, firms might outsource the
warehousing or transportation functions.
 Product Architecture Route
• In the product architecture approach, the focus is on sub-systems and
components and the make or buy decisions are made at that level. A
product like a car can be divided into sub-systems such as engine,
chassis and transmission.

• The engine sub-system can be divided into components such as

power cylinder, fuel system and engine electronics.
• In a product, first the sub-systems are classified as strategic and non
strategic. A sub-system is strategic if it involves technologies that
change rapidly, if it requires specialized skills and technologies and if it
can significantly impact the performance of the product on attributes
that are considered important by the customer.
Figure: Strategic outsourcing
process
• Tata Motors realized that in diesel engine technology it was far behind
its suppliers and will never be in a position to catch up with them. So
it decided to buy diesel engines from Fiat and treat Fiat as a strategic
partner.
• Cummins discovered that pistons were part of a strategic sub-system
but that its suppliers were far ahead in the relevant technologies
and therefore decided to buy pistons rather than make them
internally.
• Honda might treat engine technology a strategic sub-system, while
Nissan might treat transmission as a strategic sub-system. Of course,
once Tata Motors decided to source the design of diesel engine
sub-systems from the supplier, it ensured that in the other systems
kept in-house, it maintained the position of a leader.
 Assignment-1
1) What is Supply Chain management explain briefly?
2) Explain Design decisions of supply chain
3) What are the different enablers of the supply chain explain?
 Market Versus Hierarchy

The make versus buy decision is also known as the market versus hierarchy
decision in economics literature. The key issue here is to coordinate the
chain so as to provide a bundle of goods and services at the lowest cost for
a given level of service required by the customer.

The costs involved in control and coordination of internal supply is termed

agency costs in economics When a firm uses market mechanisms to
procure the necessary inputs, it may be able to take advantage of
economies of scale and also choose the supplier that supplies goods and
services at lower prices.
• There are costs incurred in the control and coordination of the
external supplier and are termed as transaction costs in economics.
 Economies of Scale
• Economies of scale are cost advantages reaped by companies when
production becomes efficient. Companies can achieve economies of
scale by increasing production and lowering costs. This happens
because costs are spread over a larger number of goods. Costs can be
both fixed and variable.
• An important part of economies of scale to understand are fixed
costs. These can take up a significant part of a business’s
expenditures.
• Fixed costs do not change with increases/decreases in units of
production volume, while variable costs fluctuate with the volume of
units of production.
For example, the airline industry has significant fixed costs. It must pay
for the airplane, the hire of the airport, and contracted salaries. Its
costs are the same whether it has one passenger or 200. So when an
airline grows bigger, it is able to attract more customers and thereby
reduce the cost per customer.
Higher volume allows a firm to
spread its fixed cost over a
larger volume of operations.
• Any manufacturing or logistics process will involve investments in fixed
costs. A firm with higher volume is able to spread its fixed costs over a
higher output and thus has lower cost of operations.

• For example, the cost of a truck trip from Mumbai to Bangalore is more
or less fixed because major costs like driver cost, bulk of fuel cost and
administrative cost are independent of the load carried by the truck.
Similarly, when a firm sets up its manufacturing unit, the set-up cost is
the same, irrespective of the volume of production. So a firm with
bigger batch sizes will have lower costs of operation.
Higher volume allows a firm to choose more efficient
technologies.

• Higher volume allows a firm to invest in technologies that are capital

intensive but result in lower fixed and variable costs per unit of
output.
• In the semiconductor industry, capital-intensive technologies capable
of handling wafers of diameter 300 millimetres allow firms to obtain
twice as many chips per wafer compared to older technologies, which
could handle wafers only with diameters up to 200 millimetres. This
allows a semiconductor manufacturing firm, willing to invest in more
capital-intensive technologies, to bring down the cost per chip.
Pooling of buffer capacities and inventories

• If firms keep their activities in-house, they have to keep buffer

capacities and inventories to take care of the uncertainties in
demand.
• A supplier, on the other hand, is able to pool uncertainties over a
larger number of customers and as a result needs much lower levels
of buffer capacity and safety inventory.
• A supplier can also ensure utilization of high capacity by pooling
demand across customers who have different demand profiles.
 Learning Curve Effect
• The learning curve captures the impact of cumulative production on
the average cost of production. The management and the workers are
able to improve their performance based on experience gained
through the cumulative production of a firm.
• In several industries, it is found that with doubling of cumulative
production the average cost declines by 10 to 20 per cent.
Agency cost
Transaction cost
Incomplete contract
 Agency cost
• The costs involved in control and coordination of internal supply is
termed agency costs in economics.
 Transaction cost
• There are costs incurred in the control and coordination of the
external supplier and are termed as transaction costs in economics. .
It includes

• Search and information cost

• Bargaining and contracting cost
• Policing and enforcing cost
• Cost incurred because of loss of control
 Incomplete contract
• In theory, it is possible to write a complete contract that stipulates each party’s
responsibilities and rights for each and every contingency that could conceivably
arise during the transactions. Unfortunately, in practice, it is impossible to write a
complete contract.
• The reasons why contracts are not complete are as follows:

• Bounded rationality
• Difficulties in specifying or measuring performance.
• Asymmetry of information.
 The Make-Versus-Buy Continuum

(a) Tapered integration, where a firm both makes and buys a given
input.

(b) Collaborative relationship, which could be a formal contractual

relation or a long-term informal relationship, based on trust. In some
cases, it can lead to alliances or joint ventures.
 Tapered Integration
Tapered integration represents a mixture of market and vertical
integration. A firm makes part of the requirement in-house and procures
the rest from the market.
Firms like Pizza Corner and Madura Garments fall in this category, wherein
they own some retail outlets and depend on franchisee or other models
for the rest of their sales.
Keeping part of the manufacturing in-house allows firms to have a better
understanding of the industry cost structures, and this helps them in
negotiating better deals with suppliers.
• Firms are able to keep up the pressure on their internal supply group to
innovate and work on cost reductions by showing them benchmark
numbers from markets. Firms can also keep the pressure on the supplier
by saying that if they do not improve the complete manufacturing will be
shifted in-house, as they have the capability for it. As this helps avoid a
potential hold-up situation, the firm is less vulnerable on this front.
• Tapered integration allows a firm the best of both worlds, if not
managed properly, the firm might end up getting the worst of both
worlds. By distributing production between internal and external supply
groups, a firm may not have economies of scale at both places. Further,
the coordination and monitoring activities might increase costs
significantly.
• TOYOTA: IN-SOURCING OF ELECTRONICS PARTS Traditionally, Denso
was the sole supplier for Toyota for all electrical and electronics parts
till 1988. In 1988, Toyota opened its own electronics manufacturing
facility, as it had recognized by the mid-1980s that electronics was
going to play an important part in automobile manufacturing. It is
estimated that, today, about 30 per cent of the total vehicle content is
related to electronics. As the share of electronics in cars is increasing
and as these technologies change at a pace faster than those of
traditional automobile technologies, Toyota identified electronics as a
core and strategic function and decided to master it so that it can
manage its suppliers effectively. They still depend a lot on Denso for
supply, but they have consciously built design and manufacturing
capability within the firm.
• Airtel has decided to shift the bulk of its call centres to external firms,
but has retained support centres for strategic customers internally so
that it does not to face coordination or communication issues with its
important patrons
 Collaborative relationship
• In a collaborative relationship, the supplier is an extension of the firm.
The firm treats its suppliers as strategic partners and usually a
supplier is assured of business for a reasonably long period of time.
• The firm does not indulge in competitive bidding every year and does
not change its supplier to get the small price reduction offered by a
competing supplier. Information is shared freely across firms, and the
supplier is willing to invest in relationship-specific assets.
• Usually, the supplier gets involved early at the product design stage
and the price paid to the supplier is based on the actual costs
incurred. One major concern in collaborative relationships is ensuring
that the supplier keeps working on innovations. Just like the internal
supplier, the partner in a collaborative relationship is assured of
business, and this may result in complacency on the part of the
supplier. Firms should periodically benchmark the partner’s costs with
the market so as to ensure that the supplier remains competitive. Dell
Computers benchmarks all its partners on cost and technology
leadership. Only if the supplier maintains leadership on both these
fronts does Dell continue with the same partner.
• Firms like Toyota buy 80 per cent of the required components from
the market. But Toyota and other Japanese firms do not keep their
suppliers at an arm’s length and do not work with contractual
relationships. Japanese manufacturers work with a network of
suppliers with whom they maintain close long-term relationships.
Japanese companies have subcontractor networks called keiretsu.
This network involves vendors, bankers and distributors. Firms within
a keiretsu are linked by informal personal relationships. As they share
long-term relationships, they avoid most of the problems associated
with market exchange relationships and are willing to invest in higher
relationship-specific assets and do not worry about information
asymmetry and hold-up problems. This allows each firm within the
keiretsu to focus on its core competence and all get the necessary
economies of scale. However, since they are assured of a market they
may also suffer from agency problems discussed in vertical integration
 Sourcing Strategy: Portfolio Approach

• Firms buy a large number of components and services and, of course,

not all of them should be handled in same way
• Packaging material and transport service markets come in this category
and represent low-risk items. Diesel engines, diesel fuel systems and
proprietary technology items have few suppliers, so they represent the
high-risk-supply category.
• For example, Bosch has a market share of 81 per cent in the fuel-injection
equipment market, so obviously it comes under the high-risk category.
Similarly, oil and steel in the early part of the 21st century represented the
high-risk category because demand outstripped supply. There was a strong
demand for steel and fuel in India and China and, as a result, demand
outstripped supply. Because of the supply uncertainty created by the
disturbances in Iraq, the supply risk for oil increased significantly after the
interventions by the United States of America in Iraq. Classifying items on
their purchasing value is a straightforward issue because it just needs
internal data and growth projections at the firm level.
Routine products.
• This quadrant represents significant opportunity. The focus is on reducing
the number of parts and the number of suppliers. The aim is to reduce
administrative and logistics complexity. The time saved here is used to
focus on strategic suppliers and bottleneck suppliers. The focus is on
moving to system buying rather than component buying. A large number
of items and suppliers come in this quarter, which represents a non-
critical, low-valued supply. Unfortunately, managers end up spending
much energy in this quarter. Ideally, the purchasing department should
not waste its energy on small items. Rather, it should aggregate
components into systems and start sourcing the systems. This issue is
discussed in greater detail in the section titled “Reconfiguration of the
Supply Base”
Leverage products.
This quadrant consists of high-value, standard products. These items
provide an opportunity for leveraging buying power in low-supply-risk
situations. In these supply markets, there are a large number of
suppliers and switching costs are low. So firms should be aggressive in
their attempts to encourage competitive bidding in order to leverage
their position. Most of the benefits obtained by firms in reverse
auctions have been in this category. A firm can reduce the number of
suppliers and focus on operational-level integration so that apart from
purchasing costs inventory and administrative efforts can also be
reduced.
Strategic products.
This quadrant represents high-value products with high supply risks. As
shown in Figure 3.4, this quadrant usually accounts for less than 5 per
cent of the items and for almost 40 per cent of purchase value. Items
in this quadrant are treated as strategic items, and a firm must work
towards establishing collaborative, long-term relationships with
suppliers in this quadrant. Firms must create opportunities for mutual
cost reduction by working together on all aspects, including product
design. Because fewer parts and suppliers are involved, firms can
invest in building collaborative relationships. The top management of
firms should get actively involved in devising a strategy for this
category of items
 Bottleneck products.
These items represent relatively low value, but a firm is vulnerable on this front
because of the supply risk inherent in this market. Since a firm is likely to be
buying relatively smaller value, it is also unlikely to have much clout with
suppliers. Here, the focus is on securing supply, and a firm should actively keep
looking at alternative sources of supply. If possible, the firm should also look at
substitutes that are from low-risk supply markets. For example, in the diesel
fuel system, there may not be too many suppliers of the required capability and
competence. A firm might try and develop a better understanding of supplier
priorities and their planning systems so that it can align its buying plan with the
suppliers’ operating plans. For example, some steel producers produce certain
grades of steel only once in a year. If an interested firm knew of their internal
processes, it might be in a better position to obtain reliable supply. If required,
the firm should also be willing to pay a premium for a reliable source of supply