supply chains: sourcingjrclass/sca/notes/10-sourcing.pdfsupply chains: sourcing jayant rajgopal,...

Department of Industrial Engineering

Supply Chains:Sourcing

Jayant Rajgopal, Ph.D., P.E.


University of Pittsburgh

Pittsburgh, PA 15261



Sourcing in Supply Chains

• How to buy goods and services required to run thefirm? Whom to buy from?

• Issues include

– In-House operations vs. Outsourcing

– Supplier assessment & selection

– Contract development

– Procurement

• Outsourcing vs. Offshoring vs. Offsourcing

© Jayant Rajgopal, 2016


In-House vs. Outsourcing

• Outsourcing to a third party can increase overall supply chainvalue. The third party might be

– more cost-effective

– more skilled or specialized

– more capable of higher quality

However…

• Outsourcing also entails risk arising from

– less control

– less security

– competitive implications



How can Outsourcing Increase Value?• Capacity Aggregation

– Yields production economies of scale beyond what a single company can obtain

– Outsourcing to these companies is best for products whose volume requirements arelower than those required to gain economies of scale

– Dell, Gateway, HP all outsource to Intel, which aggregates capacity across manymanufacturers

– BMW, Mercedes, Chrysler, Saab all outsource final assembly to Magna Steyr, whichuses flexible capacity & labor to do low volume automobile assembly (X3, G Class,Grand Cherokee, 9-3 Cabrio)

• Inventory Aggregation– Yields reduction in uncertainty and better economies of scale in purchasing &

transportation

– Outsourcing to these companies is best for products with highly uncertain andfragmented demand

– W.W.Grainger: consolidates demand for MRO supplies from many customers

– Common in many developing countries© Jayant Rajgopal, 2016


How can Outsourcing Increase Value? (cont’d)

• Transportation Aggregation

– Yields transportation economies of scale by aggregating shipments frommany customers

– Outsourcing to these companies works best for companies whoseshipments are less than full truckloads to geographically dispersedcustomers

– UPS, FedEx, Other LTL (less-than-truckload) carriers: consolidateshipments from many customers

– With storage, aggregation could be at both inbound (from severalsuppliers) and outbound sides (to several customers). E.g.,W.W.Grainger

• Warehousing Aggregation

– Benefits from lower real estate costs and lower processing costs

– Outsourcing to these companies works best for companies whosewarehousing needs are smaller or fluctuate a lot (so Wal-Mart forexample would not outsource warehousing!)



How can Outsourcing Increase Value? (cont’d)

• Information Aggregation

– Yields benefits by providing higher/more information aggregation than individualcompanies

– Adds most value when both buyers and sellers are fragmented with variabletransactions

– eBags & W.W.Grainger consolidate information for many manufacturers (through aweb-site or detailed product catalogs)

– Many on-line companies (e.g., eBay, FreeMarkets)

• Lower Costs & Higher Quality

– Yields benefits by outsourcing to a company that is specialized or located at a placewhere they can make things much cheaper

– Must consider outsourcing vs. offshoring in such cases



Outsourcing: Key PointsIn general, the three important factors in outsourcing are

• Scale: The larger the scale the lower the benefits fromoutsourcing

• Uncertainty: The more predictable the needs the less likelythat one could benefit from outsourcing

• Specifity of Assets: If the assets of the third-party are verycompany specific, the lower the chances that it can act as aneffective outsourcing agent

Bottom Line

Maximum gains from outsourcing to a third party areobtained when a company’s needs are relatively small anduncertain/variable and the third party is used by many suchcompanies.



Risks Inherent in Outsourcing• Elevated costs of coordination

– Especially important when many third parties are involved

• Reduced direct contact with customer

• Competitive implications

– Reduced internal capability

– Danger of overdependence on third party

– Leakage of sensitive data/information

• Ineffective contracts

• Use of outsourcing as a solution to fundamental flaws in theoriginal supply chain



Third Party Logistics (3PL) Providers

• Many firms that “do it all” but many that focus on specific functions

– Transportation: inbound or outbound, rail, truck, air, ship

– Warehousing: storage, facilities management

– Reverse logistics: returns, recycling

– Information technology: specialized software, information systems

– International: customs, port services

– Special skills: hazardous materials, cold chain, package delivery

• Tendency toward a blend of logistics and manufacturing in 3PL providers

• E.g., UPS, FedEx, Schneider, GENCO, i2

• 4PL Companies: assemble and integrate various services for a completelogistics solution



Supplier Scoring & Assessment

• Key Point: Suppliers should be compared not juston purchase price but based on their impact ontotal cost

• Total cost includes purchase price, cycle and safetystocks, transportation, and time required tointroduce new products

• Factors to consider include

Lead Time

On-Time Performance

Flexibility

Delivery Frequency / Minimum Lot Size

Quality

Transportation Cost

Pricing Terms

o Quantity discounts

o Payment due dates

Information Coordination Capability

Design Collaboration Capability

Exchange Rates, Taxes, Duties

Supplier Viability



Supplier Assessment: An Example

• A company buys bearings to manufacture lawn mowers & snow blowers.

• Weekly demand for bearings has a mean of 1,000 with std. dev. of 300.

• The company aims for a cycle service level of 95% and uses an annual holdingrate of 25% on the dollar; order placement and receipt costs are about $9.60per order.

• The company currently buys from a local supplier who charges $1.00 perbearing. Based on prior history, the supplier has a delivery lead time of 2weeks with a std. dev. of 1 wk.

• An overseas source has been located who claims he will discount this $1 perbearing price as long as you buy at least 8,000 at a time. However, this sourcehas a mean lead time of 6 weeks with a std. dev. of 4 wks. Also orderplacement and receipt will now run to about $10 per order.

• How much should the company be willing to pay if it decides to switchsuppliers? Would a price of $0.98 per bearing be acceptable?



Supplier Selection• Single vs. Multiple suppliers

• Selection

– Typically preceded by a qualification process

– This is followed by allowing them to bid based on cost/price

• Competitive bidding

– Sealed-bid tenders

– “Winner’s curse” phenomenon!

• Auctions

– English Auctions

– Dutch Auctions

– Vickrey Auctions

– Should the winning bidder always be selected?

– Should we worry about collusion? © Jayant Rajgopal, 2016


Contracts• Specify terms for the buyer-supplier relationship

• Have a strong effect on how the supply chain performs– Therefore they must be designed to facilitate desirable outcomes and

minimize undesirable ones!

• Key issues when developing a contract:– How does it affect the company’s profits, but also, how does it affect total

profits across the supply chain?

– How does it affect supplier performance (on different measures such ascost, time, quality, etc.)

• Objective is to develop a contract that “grows the size of the pie”as opposed to separately maximizing profits for the buyer andthe supplier.

• Design contracts that encourage a buyer to purchase more andincrease the level of product availability, but ensure that thesupplier also shares in some of the buyer’s demand uncertainty.



Common Types of Contracts• Buyback Contracts

– Supplier allows retailer to return unsold inventory, up to some specified amount,at an agreed-upon price.

– Holding cost subsidies (e.g., auto industry) & price support (e.g., high-tech) can beconsidered special cases of buy-back contracts

– E.g., booksellers, music retailers, fashion goods retailers

• Revenue-Sharing Contracts

– Supplier charges retailer a lower wholesale price, but shares a fraction of theretailer’s sales revenue

– Best suited for products with low variable costs and high return costs

– E.g., movie studios to Blockbuster

• Quantity-Flexible Contracts

– Supplier allows retailer to change the quantity ordered after observing demand;supplier guarantees supply of up to some maximum amount, and retailer agreesto buy at least some minimum amount

– Most effective when return costs are high

– E.g., Electronics and computers industry, Benetton© Jayant Rajgopal, 2016


Advantages and Disadvantages of Contracts

• Benefits

– Allows both retailer and supplier to increase profits

– Retailer’s risk is shared by supplier; in return retailer buys more andprovides higher availability

• Drawbacks

– All of these contracts could lead to lower retailer effort in case ofoverstocking; often countered by setting limits on buy-back amounts

– Additional cost of returns, salvage and disposal must all be considered(for buy-backs)

– With many retailers present, inventory is not centralized at the supplier;this disaggregation at retailers leads to more overall inventory in thesupply chain

• Retailers can sometimes reserve space or production capacity at thesupplier’s facility



Contracts: An Example (Chopra & Meindl)

• A music store buys CDs from a supplier

• Costs supplier $1 per CD, costs store (wholesale) $5 per CD and selling(retail) price is $10 per CD

• Market demand D∼N(µD=1000, σD=300)

• The Newsvendor Model applies to the retailer with cu=10-5 = $5 andco=$5

• Recall that the optimal order quantity Q is given by solvingPr(D≤Q)=cu/(co+cu)

• So optimal order quantity from Pr(D≤Q) = 0.5 yields

(Q-µD)/σD = F-1(0.5) = 0, so that Q= µD=1000

• This yields an expected profit of 1000*4 = $4,000 for the supplier and$3,803 for the retailer (can be shown using the expression for expectedprofit at the retailer…), for a total of $7,803 across the entire supplychain.



Contracts Example (cont’d)• First, suppose we consider the entire chain as a single entity.

• In this case, the Newsvendor Model applies to the system withcu=10-1 = $9 and co=$1

• So optimal order quantity from Pr(D≤Q) = 9/(9+1)= 0.9 yields(Q-µD)/σD = F-1(0.9) = 1.28, so that Q=1000+1.28*300 = 1384

• In this case the expected profit can be shown to be $8,474

• Conclusion: The music store is conservative and carries less stock(=1000) than is optimal for the entire supply chain (=1384)

• As a result the supply chain makes 8,474 – 7,803 = $671 less than itwould expect to if the retailer and supplier had worked as “oneunit.”



Contracts Example (cont’d)• Suppose we have a buy-back contract: the supplier agrees to buy back

any unsold CDs for $3

• In this case, the Newsvendor Model applies to the retailer with cu = 10-5= $5 and co=5-3=$2

• So optimal order quantity at the retailer from Pr(D≤Q) = 5/(5+2)= 0.714yields (Q-µD)/σD = F-1(0.714) = 0.566, so that Q=1000+0.566*300 = 1170

• In this case the expected profit at the retailer can be shown to be $4,286(better than $3,803) and at the supplier is $4,009 (better than $4,000) foran expected total system profit of $8,295

• Conclusion: The presence of the buy-back contract induces the retailerto buy more and even though some of this might be returned to thesupplier it still increases the supplier’s expected profit.

• This analysis ignores costs of returns…



Contracts Example (cont’d)• Suppose we have a revenue-sharing contract: the supplier agrees to sell

CDs to the retailer at cost, i.e., for $1. However, the store agrees to share45% of revenues with the supplier (so the supplier gets $4.50 per CD andthe retailer keeps $5.50)

• In this case, the Newsvendor Model applies to the retailer with cu=5.5-1 =$4.50 and co=$1

• So optimal order quantity at the retailer from Pr(D≤Q) = 4.5/(4.5+1)= 0.818yields (Q-µD)/σD=F-1(0.818) = 0.91, so that Q=1000+0.91*300 = 1273

• In this case the expected profit at the retailer can be shown to be $4,064(better than $3,803) and at the supplier is $4,367 (better than $4,000) foran expected total system profit of $8,431

• Conclusion: The presence of the revenue-sharing contract induces theretailer to buy more even though his margin is smaller ($4.50) because heonly loses $1 per disc overstocked. The supplier can expect more profitseven though he provides the CD at cost, because the retailer buys moreand passes on part of his profits.



Contracts Example (cont’d)• Suppose we have a quantity-flexible contract:

– the retailer places an initial order for 1000 CDs

– Close to the release date, as the store gets a better idea on demand it would beallowed to modify the order to anything between 800 and 1,200

• Assuming the same price structure ($1, $5 and $10), in this case, it can beshown that the order quantity for the retailer is 1,047 with an expected profitat the retailer of $4,558 (better than $3,803) and at the supplier the expectedprofit is $3,858 (worse than $4,000) for an expected total system profit of$8,416

• Here this is not a good deal for the supplier (even though the system as awhole is better off)

• However, if the original price charged to the retailer is $6 (rather than $5),then it can be shown that without the contract, expected profits at theretailer (who now orders 924 CDs) and supplier are $2,841 and $4,620 butwith the same 20% quantity-flexible contract, expected profits at retailer(who now orders 1,000 CDs) and supplier are $3,547 and $4,800

• Conclusion: Quantity-flexible contracts with proper pricing can allow bothparties to increase their expected profits. In general, the higher thewholesale price charged to the retailer the more the flexibility that ispossible.



Other types of Supplier Contracts• Coordinating Supply Chain Costs

– Quantity discounts when the optimal orderquantities do not match

• Contracts to incentivize retailer effort

– E.g.: When a retailer is pushing products frommultiple suppliers

– Two-part tariffs

– Threshold contracts

• Contracts to induce better performance

– Shared-savings contracts© Jayant Rajgopal, 2016


Design Collaboration• Crucial for collaboration with suppliers at product

design stage

– 80% of a product cost is fixed in the design stage

– 50-70% of spending is through procurement

• Can lower cost of purchased goods, manufacturingcosts and logistics

• Can speed up product development time significantly

• Especially important in highly customized products:design for postponement will allow lower inventory

• Very common in the auto industry


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