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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

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Outsourcing

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Outsourcing l.jpg

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


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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.


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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


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A Framework for Outsourcing(Fine & Whitney)


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The Move to B2B Commerce


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2003$1.3 Trillion

Business-to-Consumer

Business-to-Business

2002$843B

2001$499B

1999$109B

1998$43B

2000$251B

B2B is Huge...

Source: Forrester Research, Inc.


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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


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The company went public in 12/99...

Freemarket’s Stock Price


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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


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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


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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


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How Does FreeMarkets Online Create Value for its Customers?

  • Consulting/Purchase outsourcing

  • Distribution Intermediary


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Industrial Buyer

Manuf. Rep.

Manuf. Rep.

Manuf. Rep.

Supplier 1

Supplier 2

Supplier 3

Traditional B2B Trading Exchanges


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Industrial Buyer

FreeMarkets Online

Supplier 1

Supplier 2

Supplier 3

Internet Based B2B Trading Exchanges


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How Does FreeMarkets Online Create Value for its Customers?

  • Consulting/Purchase outsourcing

  • Distribution Intermediary

  • Network Enabler/Software Provider


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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


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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


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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


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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


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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


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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?


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By the end of 1998…

  • FreeMarkets was pursuing the horizontal market expansion

  • In 2000, the company started licensing its software


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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


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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


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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


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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)


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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


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A Framework for eProcurement

  • Level of Risk

    • Uncertain Demand (Inventory risk)

    • Volatile market price (Price Risk)

    • Component availability (Shortage Risk)


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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


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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


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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


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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


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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


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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


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A Framework for eProcurement: A Portfolio Approach

Option Level

H

L

N/A

Inventory Risk

(Supplier)

Price, Shortage Risks

(Buyer)

Inventory Risk

(Buyer)

Commitment Level

L H


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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)


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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)


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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 fee/subscription fee

Source: Forrester Research


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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


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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


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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


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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


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