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Procurement and Outsourcing. Phil Kaminsky kaminsky@ieor.berkeley.edu. David Simchi-Levi Philip Kaminsky Edith Simchi-Levi. Lecture Outline. 1) FreeMarkets Online 2) B2B Strategies 3) B2B Pitfalls 4) Outsourcing. FreeMarkets Online.

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Lecture outline

Procurement and Outsourcing

Phil Kaminskykaminsky@ieor.berkeley.edu

David Simchi-Levi

Philip Kaminsky

Edith Simchi-Levi


Lecture outline
Lecture Outline

1) FreeMarkets Online

2) B2B Strategies

3) B2B Pitfalls

4) Outsourcing


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



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.


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 customers1
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 customers2
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


Which suppliers benefit from this model
Which suppliers benefit from this model?

  • Low cost, quality suppliers will benefit as they drive competition out of the market

    • The FreeMarkets model would be beneficial for large more efficient suppliers

  • It will also provide opportunities for a host of small suppliers, especially if they are located overseas


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


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


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)


Consider instill corp
Consider Instill Corp.

  • Instill.com focuses on the food service industry and provides an infrastructure which links together operators, i.e., restaurants, distributors and manufacturers. This e-marketplace provides value to its customers by offering not only procurement services, but also forecasting, collaboration and replenishment tools.


Consider eskye com
Consider eSkye.com

  • In the alcoholic beverage industry, eSkye has tailored an offering that provides the supply chain with real value. eSkye now links retail stores, distributors and suppliers providing visibility into a supply chain where little data existed. eSkye adds value by automating the ordering process for the retailer while providing product flow information to distributors and suppliers.


Evolving market types1
Evolving Market Types

  • Private e-Markets

    • Valuechain.Dell.com (Dell), eHub (Cisco)

    • IBM, Sun Microsystems and Wal-Mart

  • These companies use the marketplace to improve supply chain collaboration

    • Providing suppliers with demand information and production data


Evolving market types2
Evolving Market Types

  • Consortia-based e-markets….

    • Covisint (automotive); Trade-Ranger (oil); Omnexus (chemicals); e2Open and Converge (high-tech)

  • Objective of the consortia is

    • Aggregate activities and use the buying power of consortia members

    • Provide suppliers with standard systems that support all buyers and allows suppliers to reduce cost


Evolving market types3
Evolving Market Types

  • Content based e-markets….

    • Focus on Maintenance, Repair and Operations (MRO) goods

      • These are components that are not part of the finished product or the manufacturing process but are essential for the business

      • Examples include lighting, office supply, fasteners,…


Lecture outline

E-marketplace Examples

Independent VerticalExchanges (IVX)

Independent Horizontal

Exchanges (IHX)

Consortia TradingExchanges (CTX)

Private Trading

Exchanges (PTX)


Private vs consortium based public markets
Private vs. consortium-based public markets

  • Owner

    • Single vs Co-Op

  • Objective

    • Private: (i) Share proprietary data (ii) allow for SC Collaboration

    • Consortia: (i) Buying/selling commodities (ii) Finding new suppliers

  • Participants

    • Private: Selected group of suppliers

    • Consortia: Open Market

  • Buyer Cost

    • Private: Building and maintaining the site

    • Consortia: Subscription fee; licensing fee


Private vs consortium based public markets1
Private vs. consortium-based public markets

  • Supplier Cost

    • Private: No fee

    • Consortia: Subscription fee; Transaction fee

  • Challenges

    • Private: Initial investment

    • Consortia: (i) Many have recently collapsed; (ii) preferred suppliers may object because of price focus; (iii) Sharing proprietary data (iv) developing standards


Private vs consortium based public markets2
Private vs. consortium-based public markets

  • Automotive Industry

    • Covisint was established in early 2000 by the Detroit’s big three automakers

    • It now also includes Renault, Nissan, Mitsubishi and Pegeot

  • Volkswagen established its own private e-market

    • Volkswagen e-market provides not only similar capabilities to that of Covisint but also real-time information on production plans so that suppliers can better utilize resources


Consider ibm
Consider IBM

  • IBM has saved about $1.7 billion since 1993 by being able to divulge sensitive price and inventory information over a private exchange built for 25,000 suppliers and customers, says Bill Paulk, IBM's vice president of e-marketplaces. As host of the exchange, the company helped defray the cost of connecting suppliers. The payoff: On-time delivery to customers soared from about 50% to close to 90%, "which helped justify the cost," Paulk says.

  • E2open: A consortia based e-marketplace established in 1999


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 eprocurement1
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 eprocurement2
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 eprocurement3
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 eprocurement4
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 reality1
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


Outsourcing
Outsourcing use exchanges):

  • 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 use exchanges):

  • 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 use exchanges):

  • 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
A Framework for Outsourcing use exchanges):(Fine & Whitney)