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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
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
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
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
b2b is huge

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.

freemarkets online
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
The company went public in 12/99...

Freemarket’s Stock Price

where is freemarkets today
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
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
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 customers12
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

Traditional B2B Trading Exchanges
internet based b2b trading exchanges

Industrial Buyer

FreeMarkets Online

Supplier 1

Supplier 2

Supplier 3

Internet Based B2B Trading Exchanges
how does freemarkets online create value for its customers15
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
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
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
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
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 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
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
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
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
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
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
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
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 eprocurement28
A Framework for eProcurement
  • Level of Risk
    • Uncertain Demand (Inventory risk)
    • Volatile market price (Price Risk)
    • Component availability (Shortage Risk)
risk commodity products
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 eprocurement30
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
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 eprocurement32
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
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 eprocurement34
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
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

b2b software vendors
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
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 reality38
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

positive aspects of trading exchanges companies who use exchanges
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
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
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
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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